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Chapter 1
Brief History of Risk and Return
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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To become a wise investor (maybe even one with too much money), you need to know:
1. How to calculate the return on an investment using different methods.
2. The historical returns on various important types of investments.
3. The historical risk on various important types of investments.
4. The relationship between risk and return.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Learning Objectives

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You can retire with One Million Dollars (or more).
How? Suppose:
You invest $300 per month.
Your investments earn 9% per year.
You decide to take advantage of deferring taxes on your investments.
It will take you about 36.25 years. Hmm. Too long.
Example I:
Who Wants To Be A Millionaire?
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Example II:
Who Wants To Be A Millionaire?
Instead, suppose:
You invest $500 per month.
Your investments earn 12% per year
you decide to take advantage of deferring taxes on your investments

It will take you 25.5 years.
Realistic?
$250 is about the size of a new car payment, and perhaps your employer will kick in $250 per month
Over the last 84 years, the S&P 500 Index return was about 12%

Try this calculator: cgi.money.cnn.com/tools/millionaire/millionaire.html

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Our goal in this chapter is to see what financial market history can tell us about risk and return.
There are two key observations:
First, there is a substantial reward, on average, for bearing risk.
Second, greater risks accompany greater returns.
These observations are important investment guidelines.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
A Brief History of Risk And Return

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Total dollar return is the return on an investment measured in dollars, accounting for all interim cash flows and capital gains or losses.

Example:

Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Dollar Returns

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Total percent return is the return on an investment measured as a percentage of the original investment.
The total percent return is the return for each dollar invested.
Example, you buy a share of stock:
Percent Returns
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Example: Calculating Total Dollar And Total Percent Returns
Suppose you invested $1,400 in a stock with a share price of $35.
After one year, the stock price per share is $49.
Also, for each share, you received a $1.40 dividend.
What was your total dollar return?
$1,400 / $35 = 40 shares
Capital gain: 40 shares times $14 = $560
Dividends: 40 shares times $1.40 = $56
Total Dollar Return is $560 + $56 = $616
What was your total percent return?
Dividend yield = $1.40 / $35 = 4%
Capital gain yield = ($49 – $35) / $35 = 40%
Total percentage return = 4% + 40% = 44%
Note that $616 divided by $1,400 is 44%.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Annualizing Returns, I

You buy 200 shares of Lowe’s Companies, Inc. at $18 per share. Three months later, you sell these shares for $19 per share. You received no dividends. What is your return? What is your annualized return?
Return: (Pt+1 – Pt) / Pt = ($19 – $18) / $18
= .0556 = 5.56%
Effective Annual Return (EAR): The return on an investment expressed on an “annualized” basis.

Key Question: What is the number of holding periods in a year?
This return is
known as the holding period percentage return.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Annualizing Returns, II

1 + EAR = (1 + holding period percentage return)m
m = the number of holding periods in a year.
In this example, m = 4 (12 months / 3 months). Therefore:

1 + EAR = (1 + .0556)4 = 1.2416.
So, EAR = .2416 or 24.16%.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
$1 Investment in Canadian S&P/TSX Index

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
A $1 Investment in Different Types of Portfolios, 1926-2009

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Financial Market History

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
The Historical Record: Total Returns on Large-Company Stocks

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
The Historical Record: Total Returns on Small-Company Stocks

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
The Historical Record: Total Returns on Long-term U.S. Bonds

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
The Historical Record: Total Returns on U.S. T-bills

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
The Historical Record: Inflation

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Historical Average Returns

A useful number to help us summarize historical financial data is the simple, or arithmetic average.
Using the data in Table 1.1, if you add up the returns for large-company stocks from 1926 through 2009, you get about 987 percent.
Because there are 84 returns, the average return is about 11.75%. How do you use this number?
If you are making a guess about the size of the return for a year selected at random, your best guess is 11.75%.
The formula for the historical average return is:

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Average Annual Returns for Five Portfolios and Inflation

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Average Annual Risk Premiums for Five Portfolios

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Average Returns: The First Lesson

Risk-free rate: The rate of return on a riskless, i.e., certain investment.

Risk premium: The extra return on a risky asset over the risk-free rate; i.e., the reward for bearing risk.
The First Lesson: There is a reward, on average, for bearing risk.
By looking at Table 1.3, we can see the risk premium earned by large-company stocks was 7.9%!
Is 7.9% a good estimate of future risk premium?
The opinion of 226 financial economists: 7.0%.
Any estimate involves assumptions about the future risk environment and the risk aversion of future investors.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
World Stock Market Capitalization

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International Equity Risk Premiums
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Why Does a Risk Premium Exist?

Modern investment theory centers on this question.
Therefore, we will examine this question many times in the chapters ahead.
We can examine part of this question, however, by looking at the dispersion, or spread, of historical returns.
We use two statistical concepts to study this dispersion, or variability: variance and standard deviation.
The Second Lesson: The greater the potential reward, the greater the risk.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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The Bear Growled and Investors Howled
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Return Variability: The Statistical Tools

The formula for return variance is (“n” is the number of returns):

Sometimes, it is useful to use the standard deviation, which is related to variance like this:

Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Return Variability Review and Concepts
Variance is a common measure of return dispersion. Sometimes, return dispersion is also call variability.
Standard deviation is the square root of the variance.
Sometimes the square root is called volatility.
Standard Deviation is handy because it is in the same “units” as the average.
Normal distribution: A symmetric, bell-shaped frequency distribution that can be described with only an average and a standard deviation.
Does a normal distribution describe asset returns?
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Frequency Distribution of Returns on Common Stocks, 1926-2009
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Example: Calculating Historical Variance and Standard Deviation

Let’s use data from Table 1.1 for Large-Company Stocks.

The spreadsheet below shows us how to calculate the average, the variance, and the standard deviation (the long way…).
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

Sheet1

(1) (2) (3) (4) (5)

Average Difference: Squared:

Year Return Return: (2) – (3) (4) x (4)

1926 11.14 11.48 -0.34 0.12

1927 37.13 11.48 25.65 657.92

1928 43.31 11.48 31.83 1013.15

1929 -8.91 11.48 -20.39 415.75

1930 -25.26 11.48 -36.74 1349.83

Sum: 57.41 Sum: 3436.77

Average: 11.48 Variance: 859.19

Standard Deviation: 29.31

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Historical Returns, Standard Deviations, and Frequency Distributions: 1926-2009
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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The Normal Distribution and Large Company Stock Returns
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Copyright © 2012 McGraw-Hill Ryerson

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Returns on Some “Non-Normal” Days
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Arithmetic Averages versus Geometric Averages

The arithmetic average return answers the question: “What was your return in an average year over a particular period?”
The geometric average return answers the question: “What was your average compound return per year over a particular period?”
When should you use the arithmetic average and when should you use the geometric average?
First, we need to learn how to calculate a geometric average.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Example: Calculating a Geometric Average Return

Let’s use the large-company stock data from Table 1.1.

The spreadsheet below shows us how to calculate the geometric average return.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

Sheet1

Percent One Plus Compounded

Year Return Return Return:

1926 11.14 1.1114 1.1114

1927 37.13 1.3713 1.5241

1928 43.31 1.4331 2.1841

1929 -8.91 0.9109 1.9895

1930 -25.26 0.7474 1.4870

(1.4870)^(1/5): 1.0826

Geometric Average Return: 8.26%

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Arithmetic Averages versus Geometric Averages

The arithmetic average tells you what you earned in a typical year.
The geometric average tells you what you actually earned per year on average, compounded annually.
When we talk about average returns, we generally are talking about arithmetic average returns.
For the purpose of forecasting future returns:
The arithmetic average is probably “too high” for long forecasts.
The geometric average is probably “too low” for short forecasts.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Geometric versus Arithmetic Averages
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Risk and Return

The risk-free rate represents compensation for just waiting.
Therefore, this is often called the time value of money.
First Lesson: If we are willing to bear risk, then we can expect to earn a risk premium, at least on average.
Second Lesson: Further, the more risk we are willing to bear, the greater the expected risk premium.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Historical Risk and Return Trade-Off
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Dollar-Weighted Average Returns, I
There is a hidden assumption we make when we calculate arithmetic returns and geometric returns.
The hidden assumption is that we assume that the investor makes only an initial investment.
Clearly, many investors make deposits or withdrawals through time.
How do we calculate returns in these cases?
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Dollar-Weighted Average Returns, II
If you only make an initial investment at the start of year one:
The arithmetic average return is 2.50%.
The geometric average return is 2.23%.
Suppose you makes a $1,000 initial investment and a $4,000 additional investment at the beginning of year two.
At the end of year one, the initial investment grows to $1,100.
At the start of year two, your account has $5,100.
At the end of year two, your account balance is $4,845.
You have invested $5,000, but your account value is only $4,845.
So, the (positive) arithmetic and geometric returns are not correct.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Dollar-Weighted Average Returns and IRR
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

The US stock market in 2000s was one of the worst decades ever in investment history, investors were better off investing in anything else, including bonds and gold.
Many investors were lured to the stock market by the bull market in 1980s through the 1990s with over 17% average returns.
For investors counting on stocks for retirement plans, the most recent decade means many have fallen behind retirement goals.
Decline in dividends presented another hurdle for stock market, playing an important role in helping achieve a 9.5% average annual return since 1926 with a yield of 4%.
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Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson
Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

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A Look Ahead
This textbook focuses exclusively on financial assets: stocks, bonds, options, and futures.
You will learn how to value different assets and make informed, intelligent decisions about the associated risks.
You will also learn about different trading mechanisms and the way that different markets function.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Useful Internet Sites
cgi.money.cnn.com/tools/millionaire/millionaire.html (millionaire link)

finance.yahoo.com (reference for a terrific financial web site)

www.globalfinancialdata.com (reference for historical financial market data—not free)

www.robertniles.com/stats (reference for easy to read statistics review)

www.tsx.com (reference for the Toronto Stock Exchange)

www.osc.gov.on.ca (reference for the Ontario Securities Commission)

Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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Returns
Dollar Returns
Percentage Returns

The Historical Record
A First Look
A Longer Range Look
A Closer Look

Average Returns: The First Lesson
Calculating Average Returns
Average Returns: The Historical Record
Risk Premiums
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Chapter Review

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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Chapter Review
Return Variability: The Second Lesson
Frequency Distributions and Variability
The Historical Variance and Standard Deviation
The Historical Record
Normal Distribution
The Second Lesson

Arithmetic Returns versus Geometric Returns
The Risk-Return Trade-Off
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

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(1)(2)(3)(4)(5)
AverageDifference:Squared:
YearReturnReturn:(2) – (3)(4) x (4)
192611.1411.48-0.340.12
192737.1311.4825.65657.92
192843.3111.4831.831013.15
1929-8.9111.48-20.39415.75
1930-25.2611.48-36.741349.83
Sum:57.41Sum:3436.77
Average:11.48Variance:859.19
29.31Standard Deviation:
PercentOne PlusCompounded
YearReturnReturnReturn:
192611.141.11141.1114
192737.131.37131.5241
192843.311.43312.1841
1929-8.910.91091.9895
1930-25.260.74741.4870
1.0826
8.26%
(1.4870)^(1/5):
Geometric Average Return:

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Chapter 2
Diversification and Risky Asset Allocation
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Learning Objectives

To get the most out of this chapter,
spread your study time across:
1. How to calculate expected returns and variances for a security.
2. How to calculate expected returns and variances for a portfolio.
3. The importance of portfolio diversification.
4. The efficient frontier and the importance of asset allocation.

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Diversification
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

Intuitively, we all know that if you hold many investments
Through time, some will increase in value
Through time, some will decrease in value
It is unlikely that their values will all change in the same way
Diversification has a profound effect on portfolio return and portfolio risk.
But, exactly how does diversification work?

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Diversification and Asset Allocation
Our goal in this chapter is to examine the role of diversification and asset allocation in investing.
In the early 1950s, professor Harry Markowitz was the first to examine the role and impact of diversification.
Based on his work, we will see how diversification works, and we can be sure that we have “efficiently diversified portfolios.”
An efficiently diversified portfolio is one that has the highest expected return, given its risk.
You must be aware that diversification concerns expected returns.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Expected Returns

Expected return is the “weighted average” return on a risky asset, from today to some future date. The formula is:

To calculate an expected return, you must first:
Decide on the number of possible economic scenarios that might occur.
Estimate how well the security will perform in each scenario, and
Assign a probability, ps, to each scenario.
(BTW, finance professors call these economic scenarios, “states.”)
The upcoming slides show how the expected return formula is used when there are two states.
Note that the “states” are equally likely to occur in this example.
BUT! They do not have to be equally likely–they can have different probabilities of occurring.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Expected Return

Suppose:
There are two stocks:
Starcents
Jpod
We are looking at a period of one year.
Investors agree that the expected return:
for Starcents is 25 percent
for Jpod is 20 percent
Why would anyone want to hold Jpod shares when Starcents is expected to have a higher return?

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Expected Return
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

The answer depends on risk
Starcents is expected to return 25 percent
But the realized return on Starcents could be significantly higher or lower than 25 percent
Similarly, the realized return on Jpod could be significantly higher or lower than 20 percent.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Calculating Expected Returns

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Expected Risk Premium

Recall:

Suppose risk free investments have an 8% return. If so,
The expected risk premium on Jpod is 12%
The expected risk premium on Starcents is 17%
This expected risk premium is simply the difference between
The expected return on the risky asset in question and
The certain return on a risk-free investment

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Calculating the Variance of Expected Returns
The variance of expected returns is calculated using this formula:

This formula is not as difficult as it appears.
This formula says:
add up the squared deviations of each return from its expected return
after it has been multiplied by the probability of observing a particular economic state (denoted by “s”).
The standard deviation is simply the square root of the variance.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Example: Calculating Expected Returns and Variances: Equal State Probabilities
Note that the second spreadsheet is only for Starcents. What would you get for Jpod?

Sheet1

Calculating Expected Returns:

Starcents: Jpod:

(1) (2) (3) (4) (5) (6)

Return if Return if

State of Probability of State Product: State Product:

Economy State of Economy Occurs (2) x (3) Occurs (2) x (5)

Recession 0.50 -0.20 -0.10 0.30 0.15

Boom 0.50 0.70 0.35 0.10 0.05

Sum: 1.00 E(Ret): 0.25 E(Ret): 0.20

Calculating Variance of Expected Returns:

Starcents:

(1) (2) (3) (4) (5) (6) (7)

Return if

State of Probability of State Expected Difference: Squared: Product:

Economy State of Economy Occurs Return: (3) – (4) (5) x (5) (2) x (6)

Recession 0.50 -0.20 0.25 -0.45 0.2025 0.10125

Boom 0.50 0.70 0.25 0.45 0.2025 0.10125

Sum: 1.00 Sum = the Variance: 0.20250

Standard Deviation: 0.45

Jmart:

(1) (2) (3) (4) (5) (6) (7)

Return if

State of Probability of State Expected Difference: Squared: Product:

Economy State of Economy Occurs Return: (3) – (4) (5) x (5) (2) x (6)

Recession 0.50 0.30 0.20 0.10 0.0100 0.00500

Boom 0.50 0.10 0.20 -0.10 0.0100 0.00500

Sum: 1.00 Sum is Variance: 0.01000

Standard Deviation: 0.10

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Expected Returns and Variances, Starcents and Jpod

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Portfolios

Portfolios are groups of assets, such as stocks and bonds, that are held by an investor.
One convenient way to describe a portfolio is by listing the proportion of the total value of the portfolio that is invested into each asset.
These proportions are called portfolio weights.
Portfolio weights are sometimes expressed in percentages.
However, in calculations, make sure you use proportions (i.e., decimals).

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Portfolios: Expected Returns

The expected return on a portfolio is a linear combination, or weighted average, of the expected returns on the assets in that portfolio.
The formula, for “n” assets, is:

In the formula: E(RP) = expected portfolio return
wi = portfolio weight for portfolio asset i
E(Ri) = expected return for portfolio asset i

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Example: Calculating Portfolio Expected Returns
Note that the portfolio weight in Jpod = 1 – portfolio weight in Starcents.

Sheet1

Calculating Expected Portfolio Returns:

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Starcents Starcents Jpod Jpod Portfolio

Return if Portfolio Contribution Return if Portfolio Contribution Return

State of Prob. State Weight Product: State Weight Product: Sum: Product:

Economy of State Occurs in Starcents: (3) x (4) Occurs in Jpod: (6) x (7) (5) + (8) (2) x (9)

Recession 0.50 -0.20 0.50 -0.10 0.30 0.50 0.15 0.05 0.025

Boom 0.50 0.70 0.50 0.35 0.10 0.50 0.05 0.40 0.200

Sum: 1.00 Sum is Expected Portfolio Return: 0.225

Calculating Variance of Expected Portfolio Returns:

(1) (2) (3) (4) (5) (6) (7)

Return if

State of Prob. State Expected Difference: Squared: Product:

Economy of State Occurs: Return: (3) – (4) (5) x (5) (2) x (6)

Recession 0.50 0.05 0.225 -0.18 0.0306 0.01531

Boom 0.50 0.40 0.225 0.18 0.030625 0.01531

Sum: 1.00 Sum is Variance: 0.03063

Standard Deviation: 0.175

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Variance of Portfolio Expected Returns

Note: Unlike returns, portfolio variance is generally not a simple weighted average of the variances of the assets in the portfolio.
If there are “n” states, the formula is:

In the formula, VAR(RP) = variance of portfolio expected return
ps = probability of state of economy, s
E(Rp,s) = expected portfolio return in state s
E(Rp) = portfolio expected return

Note that the formula is like the formula for the variance of the expected return of a single asset.

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Example: Calculating Variance of Portfolio Expected Returns

It is possible to construct a portfolio of risky assets with zero portfolio variance! What? How? (Open this spreadsheet, scroll up, and set the weight in Starcents to 2/11ths.)
What happens when you use .40 as the weight in Starcents?

Sheet1

Calculating Expected Portfolio Returns:

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Starcents Starcents Jpod Jpod Portfolio

Return if Portfolio Contribution Return if Portfolio Contribution Return

State of Prob. State Weight Product: State Weight Product: Sum: Product:

Economy of State Occurs in Starcents: (3) x (4) Occurs in Jpod: (6) x (7) (5) + (8) (2) x (9)

Recession 0.50 -0.20 0.18 -0.04 0.30 0.82 0.25 0.21 0.105

Boom 0.50 0.70 0.18 0.13 0.10 0.82 0.08 0.21 0.105

Sum: 1.00 Sum is Expected Portfolio Return: 0.209

Calculating Variance of Expected Portfolio Returns:

(1) (2) (3) (4) (5) (6) (7)

Return if

State of Prob. State Expected Difference: Squared: Product:

Economy of State Occurs: Return: (3) – (4) (5) x (5) (2) x (6)

Recession 0.50 0.209 0.209 0.00 0.0000 0.00000

Boom 0.50 0.209 0.209 0.00 0 0.00000

Sum: 1.00 Sum is Variance: 0.00000

Standard Deviation: 0.000

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Diversification and Risks

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Diversification and Risk

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The Fallacy of Time Diversification

Young people are often told that they should hold a large percent of their portfolio in stocks.
The advice could be correct, but often the typical argument used to support this advice is incorrect.
The Typical Argument: Even though stocks are more volatile, over time, the volatility “cancels out.”
Sounds logical, but the typical argument is incorrect.
This argument is the fallacy of time diversification fallacy

How can such a plausible argument be incorrect?

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The Fallacy of Time Diversification

How can such logical-sounding advice be bad?
You might remember from your statistics class that we can add variances.
This fact means that an annual variance grows each year by multiplying the annual variance by the number of years.
Standard deviations cannot be added together: An annual standard deviation grows each year by the square root of the number of years.
As we showed earlier in the chapter, a randomly selected portfolio of large-cap stocks has an annual standard deviation of about 20%.
If we held this portfolio for 16 years, the standard deviation would be about 80 percent, which is 20 percent multiplied by the square root of 16.
Bottom line: Volatility increases over time—volatility does not “cancel out” over time.
Investing in equity has a greater chance of having an extremely large value AND increases the probability of ending with a really low value.

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The Very Definition of Risk—A Wider Range of Possible Outcomes from Holding Equity

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So, Should Younger Investors Put a High Percent of Their Money into Equity?

The answer is probably still yes, but for logically sound reasons that differ from the reasoning underlying the fallacy of time diversification.
If you are young and your portfolio suffers a steep decline in a particular year, what could you do?
You could make up for this loss by changing your work habits (e.g., your type of job, hours, second job).
People approaching retirement have little future earning power, so a major loss in their portfolio will have a much greater impact on their wealth.
Thus, the portfolios of young people should contain relatively more equity (i.e., risk).

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Why Diversification Works

Correlation: The tendency of the returns on two assets to move together. Imperfect correlation is the key reason why diversification reduces portfolio risk as measured by the portfolio standard deviation.
Positively correlated assets tend to move up and down together.
Negatively correlated assets tend to move in opposite directions.
Imperfect correlation, positive or negative, is why diversification reduces portfolio risk.

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Why Diversification Works

The correlation coefficient is denoted by Corr(RA, RB) or simply, A,B.
The correlation coefficient measures correlation and ranges from -1 to 1:

-1 (perfect negative correlation)
0 (uncorrelated)
+1 (perfect positive correlation)

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Why Diversification Works

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Why Diversification Works
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Calculating Portfolio Risk
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For a portfolio of two assets, A and B, the variance of the return on the portfolio is:
Where: xA = portfolio weight of asset A
xB = portfolio weight of asset B
such that xA + xB = 1.
(Important: Recall Correlation Definition!)

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The Importance of Asset Allocation
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Suppose that as a very conservative, risk-averse investor, you decide to invest all of your money in a bond mutual fund. Very conservative, indeed?

Uh, is this decision a wise one?

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Correlation and Diversification
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The various combinations of risk and return available all fall on a smooth curve.
This curve is called an investment opportunity set, because it shows the possible combinations of risk and return available from portfolios of these two assets.
A portfolio that offers the highest return for its level of risk is said to be an efficient portfolio.
The undesirable portfolios are said to be dominated or inefficient.

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More on Correlation and the Risk-Return Trade-Off
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Example: Correlation and the
Risk-Return Trade-Off, Two Risky Assets
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Sheet1

Expected Standard

Inputs Return Deviation

Risky Asset 1 14.0% 20.0%

Risky Asset 2 8.0% 15.0%

Correlation 30.0%

Percentage

in Risky Standard Expected

Asset 1 Deviation Return

-60.0% 23.4% 4.4%

-50.0% 21.7% 5.0%

-40.0% 20.1% 5.6%

-30.0% 18.6% 6.2%

-20.0% 17.2% 6.8%

-10.0% 16.0% 7.4%

0.0% 15.0% 8.0%

10.0% 14.2% 8.6%

20.0% 13.7% 9.2%

30.0% 13.6% 9.8%

42.9% 13.8% 10.6%

50.0% 14.2% 11.0%

60.0% 14.9% 11.6%

70.0% 15.9% 12.2%

80.0% 17.1% 12.8%

90.0% 18.5% 13.4%

100.0% 20.0% 14.0%

110.0% 21.6% 14.6%

120.0% 23.3% 15.2%

130.0% 25.0% 15.8%

140.0% 26.8% 16.4%

Sheet1

Standard Deviation
Expected Return
Efficient Set–Two Asset Portfolio

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The Importance of Asset Allocation
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We can illustrate the importance of asset allocation with 3 assets.
How? Suppose we invest in three mutual funds:
One that contains Foreign Stocks, F
One that contains U.S. Stocks, S
One that contains U.S. Bonds, B

Figure 11.6 shows the results of calculating various expected returns and portfolio standard deviations with these three assets.

Expected Return Standard Deviation
Foreign Stocks, F 18% 35%
U.S. Stocks, S 12 22
U.S. Bonds, B 8 14

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Risk and Return with Multiple Assets
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Risk and Return with Multiple Assets
We used these formulas for portfolio return and variance:

But, we made a simplifying assumption. We assumed that the assets are all uncorrelated.
If so, the portfolio variance becomes:
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The Markowitz Efficient Frontier

The Markowitz Efficient frontier is the set of portfolios with the maximum return for a given risk AND the minimum risk given a return.
For the plot, the upper left-hand boundary is the Markowitz efficient frontier.
All the other possible combinations are inefficient. That is, investors would not hold these portfolios because they could get either
more return for a given level of risk
or
less risk for a given level of return.

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Investors face two problems with they form portfolios of multiple securities from different asset classes.
These are as follows: an asset allocation problem & a security selection problem.
The asset allocation problem involves a decision regarding what percentage should be allocated among different asset classes ( stocks, bonds, derivatives, foreign securities).
The security selection problem involves deciding which to pick in each class and what percentage to allocate to these securities (RIM, Royal Bank, Molson).
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Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

Professional Investors have traditionally used modern portfolio theory to help make investment decisions.
This approach examines past returns, volatility and correlation to determine the optimum percentage of a portfolio to invest in to achieve an expected rate of return for a given level of risk.
“Modern Portfolio theory focuses on diversifying your risk away, but the crisis has shown the limits of the approach.”
What are the alternatives?
How should investors be looking to construct their portfolios?
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Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

Investors should make asset allocations that give the best chance of meeting their own unique future financial commitments, rather then simply trying to maximize risk-adjusted returns.
Life cycle investing, takes into account the investor’s specific time horizons, something that modern portfolio theory does not take into account.
Controlling the overall risk level of investments to make sure it is in line with risk appetite.
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Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

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Useful Internet Sites
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Copyright © 2012 McGraw-Hill Ryerson

www.investopedia.com (for more on risk measures)

www.teachmefinance.com (also contains more on risk measure)

www.morningstar.com (measure diversification using “instant x-ray”)

www.moneychimp.com (review modern portfolio theory)

www.efficientfrontier.com (check out the reading list)

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Chapter Review

Expected Returns and Variances
Expected returns
Calculating the variance
Portfolios
Portfolio weights
Portfolio expected returns
Portfolio variance

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Chapter Review

Diversification and Portfolio Risk
The principle of diversification
The fallacy of time diversification
Correlation and Diversification
Why diversification works
Calculating portfolio risk
More on correlation and the risk-return trade-off
The Markowitz Efficient Frontier
Risk and return with multiple assets

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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Risky Asset 28.0%15.0%
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Chapter 3
The Investment Process
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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The Investment Process
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Copyright © 2012 McGraw-Hill Ryerson
“Don’t Gamble! Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it.”
– Will Rogers

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Don’t sell yourself short. Instead, learn about these key investment subjects:

1. The importance of an investment policy statement.
2. The various types of securities brokers and brokerage accounts.
3. How to calculate initial and maintenance margin.
4. The workings of short sales.
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Learning Objectives

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Investing Overview
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Fundamental Question: Why invest at all?
We invest today to have more tomorrow.
Investment is simply deferred consumption.
We choose to wait because we want more to spend later.
Investors have their own investment objectives and strategies
The Investment Policy Statement (IPS)
Designed to reflect your objectives and strategies
Two parts
Objectives
Constraints

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Objectives: Risk and Return
In formulating investment objectives, the individual must balance return objectives with risk tolerance.
Investors must think about risk and return.
Investors must think about how much risk they can handle.
Your risk tolerance is affected by
Your ability to take risk
Your willingness to take risk

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Investor Constraints

Resources. What is the minimum sum needed? What are the associated costs? Trading commissions? Subsequent transactions?

Horizon. When do you need the money? Buying a home? Retirement?

Liquidity. How high is the possibility that you need to sell the asset quickly? Are funds for emergency purposes or long term goals?

Taxes. Which tax bracket are you in? After tax returns are essential

Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions?

Investment management. Should you manage your investments yourself? Investment Advisor or Broker? Financial Planner?

Market timing. Should you try to buy and sell in anticipation of the future direction of the market?
Asset allocation. How should you distribute your investment funds across the different classes of assets? Dependent on your risk tolerance
Security selection. Within each class, which specific securities should you buy? Which stock and bonds to invest funds in & what percentage of funds to invest in each security?

Is asset allocation or security selection more important to the success of a portfolio?
Most people are inclined to think security selection is the more important element for successful investing.
Research shows, however, that asset allocation is the more important determinant of portfolio returns. Many experts suggest:
About 90 percent of portfolio performance stems from asset allocation.
So, 10 percent of portfolio performance comes from security selection.
How is this result possible? Well, consider the Crash of 2008.
Bonds outperformed stocks in 2008
Even those elusive “skilled stock pickers” might underperform bonds
Stocks tend to move together
Even a “skilled stock picker” would have trouble beating bonds if most stock prices are performing poorly relative to bond prices

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Copyright © 2012 McGraw-Hill Ryerson
Choosing a Broker/Advisor
What do you do after carefully crafting your Investment Policy Statement (IPS)?
If so, you need to choose the type of brokerage account and your broker/advisor from:
full-service brokers
discount brokers
deep-discount brokers
These three groups can be distinguished by the level of service provided, as well as the level of commissions charged.

As the brokerage industry becomes more competitive, the differences among broker types continues to blur.
Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers.
Online investing has really changed the brokerage industry.
slashing brokerage commissions
providing investment information
Customers place buy and sell orders over the Internet
Many full-service brokers offer an advisory-based relationship for clients.
Rather than charging commissions on every transaction, the investment advisor charges an annual fee, say 1-2%, based on the account balance.
This fee covers all services associated with advice and trading.
An advisory-based relationship can align the interests of the client and the advisor.

There are several important things to remember when you deal with any broker/advisor:
Any advice you receive is not guaranteed.
Your broker works as your agent and has a legal duty to act in your best interest.
Brokerage firms, however, do make profits from brokerage commissions and/or annual fees.

Your account agreement will probably specify that any disputes will be settled by arbitration and that the arbitration is final and binding.

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Canadian Investor Protection Fund
Canadian Investor Protection Fund (CIPF): Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties.
Most brokerage firms belong to the CIPF, which insures each account for up to $1,000,000 in cash and securities
Important: The CIPF does not guarantee the value of any security
Rather, CIPF protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure.

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Copyright © 2012 McGraw-Hill Ryerson
Opening Your Brokerage Account
(c) Buy 100 Shares
of Disney
at $33 per share
(e) $6,650 Cash
in Account
$3,300 Stock
In Account
(d) Pay Commission,
Say $50
(b) Deposit $10,000
into account
(a) Open a brokerage
or trading account

A Cash account is a brokerage account in which securities are paid for in full.

A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit.

(more on selling short later)

In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin.
Of course, the portion that is borrowed incurs an interest charge.
This interest is based on the broker’s call money rate.
The call money rate is the rate brokers pay to borrow money to lend to customers in their margin accounts.

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Example: Margin Accounts, The Balance Sheet
You buy 1,000 Pfizer (PFE) shares at $24 per share.
You put up $18,000 and borrow the rest.
Amount borrowed = $24,000 – $18,000 = $6,000
Margin = $18,000 / $24,000 = 75%

Assets Liabilities and
Account Equity
1,000 Shares, PFE $ 24,000 Margin Loan $ 6,000
Account Equity $ 18,000
Total $ 24,000 Total $ 24,000

In a margin purchase, the minimum margin that must be supplied is called the initial margin.
The maintenance margin is the margin amount that must be present at all times in a margin account.
When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call.

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Example: The Workings of a Margin Account
Your margin account requires:
an initial margin of 50%, and
a maintenance margin of 30%
A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50.

You have $20,000, and you want to buy as much WHOA as you can.
You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.

Assets Liabilities and
Account Equity
800 Shares of WHOA @ $50/share $ 40,000 Margin Loan $ 20,000
Account Equity $ 20,000
Total $ 40,000 Total $ 40,000

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Example: The Workings of a Margin Account
After your purchase, shares of WHOA fall to $35. (Woe!)
New margin = $8,000 / $28,000 = 28.6% < 30% Therefore, you are subject to a margin call. Assets Liabilities and Account Equity 800 Shares of WHOA @ $35/share $ 28,000 Margin Loan $ 20,000 Account Equity $ 8,000 Total $ 28,000 Total $ 28,000 * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Effects of Margin You have $30,000 in a margin account, 60% initial margin required. You can buy $50,000 of stock with this account (why?). Your borrowing rate from your broker is 6.00%. Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share. Assume no dividends, and that your borrowing rate is still 6.00%, what is your return if: In one year, KO is selling for $60 per share? In one year, KO stock is selling for $60 per share, but you did not borrow money from your broker? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Effects of Margin KO is selling for $60 per share. Your investment is worth $60,000. You owe 6% on the $20,000 you borrowed: $1,200. If you pay off the loan with interest, your account balance is: $60,000 – $21,200 = $38,800. You started with $30,000. Therefore, your return is $8,800 / $30,000 = 29.33%. Suppose Coca-Cola stock was selling for $40 per share instead of $60 per share? What is your return? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Effects of Margin Coca-Cola stock is selling for $60 per share, but you did not borrow from your broker. You started with $30,000, which means you were able to buy $30,000 / $50 = 600 shares. Your investment is now worth $36,000. Therefore, your return is $6,000 / $30,000 = 20.00%. Suppose Coca-Cola is selling for $40 per share instead of $60 per share. What is your return in this case? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: How Low Can it Go? Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55 per share. Total cost: $16,500 You have only $9,900—so you must borrow $6,600. Your initial margin is $9,900/$16,500 = 60%. Suppose your maintenance margin is 40%. At what price will you receive a margin call? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: How Low Can it Go? (Answer) This will happen when the price of Pepsico, Inc. drops to $36.67. How so? Well, * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Annualizing Returns on a Margin Purchase You buy 1,000 shares of Costco (COST) at $60 per share. Your initial margin is 50%. You borrow at the 9 percent call money rate plus 2 percent. You sell Costco (COST) 4 months later for $63. There were no dividends paid (and suppose the prices above are net of commissions). What is your holding period percentage return and your EAR? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Annualizing Returns on a Margin Purchase Answer: First, you have to repay the 3-month loan, so t = (3/12 = .25) Amount Repaid = Amount Borrowed × (1 + interest rate per year)t Amount Repaid = $30,000 × (1 + .11).25 = $30,000 × 1.02643 = $30,792.90 Your Sale Proceeds = Cash from Sale – Amount Repaid = $63,000 – 30,792.90 = $32,207.10 Your Profit = Your Sale Proceeds – Your Investment = $32,207.10 - $30,000 = $2,207.10 * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Annualizing Returns on a Margin Purchase Note that there are 12/3 = 4 three-month holding periods in a year. Therefore, m = 4. * * * Hypothecation and Street Name Recognition Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Hypothecation is the act of pledging securities as a collateral against a loan. This pledge is needed so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call. Street name registration is an arrangement under which a broker is the registered owner of a security. (You, as the account holder are the “beneficial owner.”) * * Other Account Issues Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Trading accounts can also be differentiated by the ways they are managed. Advisory account - You pay someone else to make buy and sell decisions on your behalf. Wrap account - All the expenses associated with your account are “wrapped” into a single fee. Discretionary account - You authorize your broker to trade for you. Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans. * * Other Account Issues Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson To invest in financial securities, you do not need an account with a broker. One alternative is to buy securities directly from the issuer. Another alternative is to invest in mutual funds. * * Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Short Sale is a sale in which the seller does not actually own the security that is sold. Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position.” Borrow shares from someone Sell the Shares in the market Buy shares From the market Return the shares Today In the Future * * Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson An investor with a long position benefits from price increases. Easy to understand You buy today at $34, and sell later at $57, you profit! Buy low, sell high An investor with a short position benefits from price decreases. Also easy to understand You sell today at $83, and buy later at $27, you profit. Sell high, buy low * * Example: Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson You short 100 shares of Verizon Communications (VZ) at $30 per share. Your broker has a 50% initial margin and a 40% maintenance margin on short sales. The value of stock borrowed that will be sold short is: $30 × $100 = $3,000 Assets Liabilities and Account Equity Sale Proceeds $ 3,000 Short Position $ 3,000 Initial Margin Deposit $ 1,500 Account Equity $ 1,500 Total $ 4,500 Total $ 4,500 * * Example: Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Verizon Communications stock price falls to $20 per share. Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000. Also, new margin: $2,500 / $2,000 = 125% Assets Liabilities and Account Equity Sale Proceeds $ 3,000 Short Position $ 2,000 Initial Margin Deposit $ 1,500 Account Equity $ 2,500 Total $ 4,500 Total $ 4,500 * * Example: Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Verizon Communications stock price rises to $40 per share. You sold short at $30, stock price is now $40, you are "behind" by $10 per share, or $1,000. (“He who sells what isn’t his’n, must buy it back—or go to prison.”) Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call. Assets Liabilities and Account Equity Sale Proceeds $ 3,000 Short Position $ 4,000 Initial Margin Deposit $ 1,500 Account Equity $ 500 Total $ 4,500 Total $ 4,500 * * More on Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Short interest is the amount of common stock held in short positions. In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers. Note that with a short position, you may lose more than your total investment, as there is no theoretical limit to how high the stock price may rise. Short Sellers face Constraints. From government intervention Also, there might not be enough shares available to borrow to short sell. Constraints reduce liquidity, increase volatility, and lead to inefficient pricing. * * Finding Actual Short Positions (from finance.yahoo.com) Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Forming a Real Investment Portfolio Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Take the Risk Tolerance Quiz in the textbook. What score did you get? * Forming a Real Investment Portfolio What does your score mean? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Useful Internet Sites Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson www.finra.org (a reference for dispute resolution) www.bearmarketcentral.com (a reference for short selling) www.nasdaq.com (a reference for short interest) www.moneycentral.msn.com (a reference for building a portfolio—search the site for “Build your first stock portfolio”) www.sharebuilder.com (a reference for opening a brokerage account) www.buyandhold.com (another reference for opening a brokerage account) www.individual.ml.com (a risk tolerance questionnaire from Merrill Lynch) www.money-rates.com (a reference for current broker call money rate) finance.yahoo.com (a reference for short sales on particular stocks) * * * The importance of an investment policy statement (IPS). The investment policy statement (IPS) identifies the objectives (risk and return) of an investor, as well as the constraints the investor faces in achieving these objectives. The IPS provides an investing “roadmap” and will influence the strategies, type of account, and holdings an investor chooses. The various types of securities brokers Choosing a Broker Online Brokers Security Investors Protection Corporation Broker-Customer Relations Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review * 81 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * * Brokerage Accounts Cash Accounts Margin Accounts and how to calculate initial and maintenance margin A Note on Annualizing Returns Short Sales Basics of a Short Sale Some Details Forming a Real Investment Portfolio Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review * 82 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of ( ) $36.67. 0.60 22 0.40 - 1 300 $6,600 P here, So Level Margin e Maintenanc - 1 Shares of Number Borrowed Amount P in results , P price, stock critical the for Solving P Shares of Number Borrowed Amount P Shares of Number Level Margin e Maintenanc * * * * * = = = = ´ - ´ = 32.85%. about is EAR your So 1.3285 0.0736) (1 Return) Percentage Period Holding (1 EAR 1 0.0736 $30,000 $2,207.10 $30,000 $30,000 - $32,207.10 Return Percentage Period Holding 4 m = + = + = + = = = 1 Chapter 4 Overview of Security Types Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * 205 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * Price quotes for all types of investments are easy to find, but what do they mean? Learn the answers for: 1. Various types of interest-bearing assets. 2. Equity securities. 3. Futures contracts. 4. Option contracts. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Learning Objectives * * Our goal in this chapter is to introduce the different types of securities that investors routinely buy and sell in financial markets around the world. For each security type, we will examine: Its distinguishing characteristics Its potential gains and losses How its prices are quoted in the financial press. Security Types Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Classifying Securities Basic Types Major Subtypes Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Futures Options * * Money market instruments are short-term debt obligations of large corporations and governments. These securities promise to make one future payment. When they are issued, their lives are less than one year. Fixed-income securities are longer-term debt obligations of corporations and governments. These securities promise to make fixed payments according to a pre-set schedule. When they are issued, their lives exceed one year. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Interest Bearing Assets * * Examples: U.S. Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments. Potential gains/losses: A known future payment, except when the borrower defaults (i.e., does not pay). Price quotations: Usually, the instruments are sold on a discount basis, and only the interest rates are quoted. Therefore, investors must be able to calculate prices from the quoted rates. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Money Market Instruments * * Examples: Treasury notes, corporate bonds, car loans, student loans. Potential gains/losses: Fixed coupon payments and final payment at maturity, except when the borrower defaults. Possibility of gain (loss) from fall (rise) in interest rates Depending on the debt issue, illiquidity can be a problem. Illiquidity means that you might not be able to sell securities quickly for their current market value. Fixed Income Securities Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Price Quotations from www.wsj.com—the online version of The Wall Street Journal (some columns are self-explanatory): Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Quote Example: Fixed Income Securities You will receive 2.20% of the bond’s face value each year in 2 semi-annual payments. The price (per $100 face) of the bond when it last traded. The Yield to Maturity (YTM) of the bond. * * Common stock: Represents ownership in a corporation. A part owner receives a pro rated share of whatever is left over after all obligations have been met in the event of a liquidation. Preferred stock: The dividend is usually fixed and must be paid before any dividends for the common shareholders. In the event of a liquidation, preferred shares have a particular face value. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Equities * * Examples: RIM shares, Microsoft shares, Tim Horton's shares, Dell shares, etc. Potential gains/losses: Many companies pay cash dividends to their shareholders. However, neither the timing nor the amount of any dividend is guaranteed. The stock value may rise or fall depending on the prospects for the company and market-wide circumstances. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Common Stock * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Common Stock Price Quotes * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Common Stock Price Quotes Online at http://finance.yahoo.com First, enter symbol. Resulting Screen * * Information is a bit harder to find for preferred stock versus common stock. Example: Bank of America (BAC) preferred stock Find all the BAC preferred stock issues via a Google search—one source is: quantumonline.com. One issue has a ticker of: BAC-J (BAC-PJ is its symbol at Yahoo!) Potential gains/losses: Dividends are “promised.” However, there is no legal requirement that the dividends be paid, as long as no common dividends are distributed. The stock value may rise or fall depending on the prospects for the company and market-wide circumstances. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Preferred Stock * * Primary asset: Security originally sold by a business or government to raise money. Derivative asset: A financial asset that is derived from an existing traded asset, rather than issued by a business or government to raise capital. More generally, any financial asset that is not a primary asset. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Derivatives * * Futures contract: An agreement made today regarding the terms of a trade that will take place later. Option contract: An agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Derivatives * * Examples: financial futures (i.e., TSX/S&P, S&P 500, T-bonds, foreign currencies, and others), commodity futures (i.e., wheat, crude oil, cattle, and others). Potential gains/losses: At maturity, you gain if your contracted price is better than the market price of the underlying asset, and vice versa. If you sell your contract before its maturity, you may gain or lose depending on the market price for the contract. Note that enormous gains and losses are possible. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Futures Contracts * * Source: Markets Data Center at www.wsj.com. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Futures Contracts: Online Price Quotes * * Source: www.cmegroup.com Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Futures Price Quotes Online * * A call option gives the owner the right, but not the obligation, to buy something, while a put option gives the owner the right, but not the obligation, to sell something. The “something” can be an asset, a commodity, or an index. The price you pay today to buy an option is called the option premium. The specified price at which the underlying asset can be bought or sold is called the strike price, or exercise price. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Options Contracts * * An American option can be exercised anytime up to and including the expiration date, while a European option can be exercised only on the expiration date. Options differ from futures in two main ways: Holders of call options have no obligation to buy the underlying asset. Holders of put options have no obligation to sell the underlying asset. To avoid this obligation, buyers of calls and puts must pay a price today. Holders of futures contracts do not pay for the contract today. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Options Contracts * * Potential gains and losses from call options: Buyers: Profit when the market price minus the strike price is greater than the option premium. Best case, theoretically unlimited profits. Worst case, the call buyer loses the entire premium. Sellers: Profit when the market price minus the strike price is less than the option premium. Best case, the call seller collects the entire premium. Worst case, theoretically unlimited losses. Note that, for buyers, losses are limited, but gains are not. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Options Contracts * * Potential gains and losses from put options: Buyers: Profit when the strike price minus the market price is greater than the option premium. Best case, market price (for the underlying) is zero. Worst case, the put buyer loses the entire premium. Sellers: Profit when the strike price minus the market price is less than the option premium. Best case, the put seller collects the entire premium. Worst case, market price (for the underlying) is zero. Note that, for buyers and sellers, gains and losses are limited. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Options Contracts * * Source: www.finance.yahoo.com Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Options Contracts: Online Price Quotes for Nike (NKE) Options * * Stocks: Suppose you have $10,000 for investments. Macron Technology is selling at $50 per share. Number of shares bought = $10,000 / $50 = 200 If Macron is selling for $55 per share 3 months later, gain = ($55  200) - $10,000 = $1,000 If Macron is selling for $45 per share 3 months later, gain = ($45  200) - $10,000 = -$1,000 Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Investing in Stocks versus Options * * Options: A call option with a $50 strike price and 3 months to maturity is also available at a premium of $4. Traded option contracts are on a bundle of 100 shares. One call contract costs $4  100 = $400, so number of contracts bought = $10,000 / $400 = 25 (for 25  100 = 2,500 shares) If Macron is selling for $55 per share 3 months later, gain = {($55 – $50)  2,500} - $10,000 = $2,500 If Macron is selling for $45 per share 3 months later, loss = ($0  2,500) – $10,000 = -$10,000 Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Investing in Stocks versus Options * * www.m-x.ca (Montreal Exchange) www.nasdbondinfo.com (current corporate bond prices) www.investinginbonds.com (bond basics) www.finra.com (learn more about TRACE) www.fool.com (Are you a “Foolish investor”?) www.stocktickercompany.com (reproduction stock tickers) www.cmegroup.com (CME Group) www.cboe.com (Chicago Board Options Exchange) finance.yahoo.com (prices for option chains) www.wsj.com (online version of The Wall Street Journal) Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Useful Internet Sites * * Classifying Securities Interest-Bearing Assets Money Market Instruments Fixed-Income Securities Equities Common Stock Preferred Stock Common and Preferred Stock Price Quotes Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review * 34 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * Derivatives Futures Contracts Futures Price Quotes Gains and Losses on Futures Contracts Option Contracts Option Terminology Options versus Futures Option Price Quotes Gains and Losses on Option Contracts Investing in Stocks versus Options Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review * 35 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of 1 Chapter 5 Mutual Funds Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * 1 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Learning Objectives You are probably going to be a mutual fund investor very soon, so you should definitely know the following: The different types of mutual funds. How mutual funds operate. How to find information about how mutual funds have performed. The workings of Exchange Traded Funds and hedge funds. The workings of Registered Retirement Saving Plans. The workings of Income Trusts. * * * Mutual Funds: Overview Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Our goal in this chapter is to understand the different types of mutual funds, their risks, and their returns. As of the end of 2009, Canadian investors held an estimated 48 million mutual fund accounts. Twenty one years ago, Canadian investors had only 2.5 million accounts. The mutual fund industry grew from $21 billion to $595 billion in the same period. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Funds: Overview Mutual funds are simply a means of combining or pooling the funds of a large group of investors. The buy and sell decisions for the resulting pool are then made by a fund manager, who is compensated for the service provided. Like commercial banks and life insurance companies, mutual funds are a form of financial intermediary. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Investment Companies and Fund Types An Investment company is business that specializes in pooling funds from individual investors and making investments. An Open-end fund is an investment company that stands ready to buy and sell shares in itself to investors, at any time. A Closed-end fund is an investment company with a fixed number of shares that are bought and sold by investors, only in the open market. Sometimes, if an open-end fund gets too big, it will not take in new investors. It will, however, take more money from its current investors. Of course, current investors can withdraw money from the fund. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Investment Companies and Fund Types * * * Investment Companies and Fund Types Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Net asset value (NAV) is the value of the assets held by a mutual fund, divided by the number of shares. Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any time. In contrast, share value of closed-end funds may differ from their NAV. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Operations Organization and Creation A mutual fund is simply a corporation. It is owned by shareholders, who elect a board of directors. Most mutual funds are created by investment advisory firms (say Fidelity Investments) or brokerage firms with investment advisory operations (say Merrill Lynch). Investment advisory firms earn fees for managing mutual funds. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Operations The Fund Prospectus and Annual Report Mutual funds are required by law to supply a prospectus to any investor who wishes to purchase shares. Mutual funds must also provide an annual report to their shareholders. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Costs and Fees Types of Expenses and Fees Sales charges or “loads” Front-end loads are charges levied on purchases. Back-end loads are charges levied on redemptions. 12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs. Management fees: Usually range from 0.25% to 1.00% of the funds total assets each year. Are usually based on fund size and/or performance. Trading costs Not reported directly Funds must report "turnover," which is related to the amount of trading. The higher the turnover, the more trading has occurred in the fund. The more trading, the higher the trading costs. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Costs and Fees Expense Reporting Mutual funds are required to report expenses in a fairly standardized way in their prospectus. Shareholder transaction expenses - loads and deferred sales charges. Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director fees. Funds report a hypothetical example showing total expenses paid by investors per $10,000 invested. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Fee Table * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Costs and Fees Why Pay Loads and Fees? After all, many good no-load funds exist. But, you may want a fund run by a particular manager. All such funds are load funds. Or, you may want a specialized type of fund. Perhaps one that specialized in Italian companies Loads and fees for specialized funds tend to be higher, because there is little competition among them. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Short-Term Funds Short-term funds are collectively known as money market mutual funds. Money market mutual funds (MMMFs) are mutual funds specializing in money market instruments. MMMFs maintain a $1.00 net asset value to make them resemble bank accounts. There is no guarantee that the net asset value will be $1.00 or more. A Net Asset Value for a MMMF under $1.00 results in the term, “breaking the buck.” Following the Crash of 2008, a few MMMF “broke the buck.” * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Short-Term Funds Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs. The distinction is that a bank money market account is a bank deposit and offers CDIC protection. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Long-Term Funds There are many different types of long-term funds, i.e., funds that invest in long-term securities. Historically, mutual funds were classified as stock funds, bond funds, or balanced funds. Today, the investment objective of the fund is the major determinant of the fund type. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Stock Funds Some stock funds trade off capital appreciation and dividend income. Capital appreciation Growth Growth and Income Equity income Some stock funds focus on companies in a particular size range. Small company Mid-cap Large-cap Some stock fund invest internationally. Global International Region Country Emerging markets * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Stock Funds Sector funds specialize in specific sectors of the economy, such as: Biotechnology Internet Energy Other fund types include: Index funds Social conscience, or “green,” funds “Sin” funds (i.e., tobacco, liquor, gaming) Tax-managed funds * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Bond Funds Bond funds may be distinguished by their Maturity range Credit quality Taxability Bond type Issuing country Bond fund types include: Short-term and intermediate-term funds General funds High-yield funds Mortgage funds World funds Insured funds * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Stock and Bond Funds Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid” funds. Examples include: Balanced funds Asset allocation funds Convertible funds Income funds Target Date Funds (also known as Lifecycle Funds) The asset allocation chosen by target date funds is based on the anticipated retirement date of the investors holding the fund. If a company offers a Target Date 2040 Fund, the fund is for people planning to retire in about 2040. In 2011, say, this fund would have a large equity exposure. In 2039, say, this fund would have a large bond exposure. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Objectives: A mutual fund “style” box is a way of visually representing a fund’s investment focus by placing the fund into one of nine boxes: Growth Blend Value Large Medium Small Size Style * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Objectives: Recent Developments In recent years, there has been a trend toward classifying a mutual fund’s objective based on its actual holdings. For example, the Wall Street Journal classifies most general purpose funds based on the market “cap” of the stocks they hold whether the fund tends to invest in “growth” or “value” stocks (or both). Growth stocks are those considered more likely to grow their businesses. Value stocks are those that look to be relatively undervalued. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Objectives * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Performance Mutual fund performance is very closely tracked by a number of organizations. Financial publications of all types periodically provide mutual fund data. The Wall Street Journal is particularly timely print source. www.morningstar.com has a “Fund Selector” that provides performance information. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Selection (www.morningstar.com) Our Screen: domestic stock fund; small-cap growth; low expenses; no loads * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Mutual Fund Performance: Yardsticks * * Mutual Fund Performance: Online Version of The Wall Street Journal Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * Mutual Fund Performance: Online Version of The Wall Street Journal Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * Mutual Fund Performance: Cautions Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson While looking at historical returns, the riskiness of the various fund categories should also be considered. Whether historical performance is useful in predicting future performance is a subject of ongoing debate. Some of the poorest-performing funds are those with very high costs. * Closed Funds Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Sometimes a fund will choose to close. This means that the fund will no longer sell shares to new investors. The use of the word “close” here should not be confused with “closed-end.” The number of shares in a closed fund can still fluctuate as existing owners buy and sell. Why would a fund choose to close? When a fund grows rapidly, the fund manager may feel that the incoming cash is more than the fund can invest profitably. Funds that close often reopen at a later date. * Closed-End Funds Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson A closed-end fund has a fixed number of shares. These shares are traded on stock exchanges. There are about 600 closed-end funds that have their shares listed on U.S. Stock Exchanges. There are about 8,000 long-term open-end mutual funds. * Mutual Fund Performance: Closed-End Funds Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The Closed-End Funds Discount Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Most closed-end funds sell at a discount relative to their net asset values. The discount is sometimes substantial. The typical discount fluctuates over time. Despite a great deal of academic research, the closed-end fund discount phenomenon remains largely unexplained. * Exchange Traded Funds, ETFs Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson An exchange traded fund, or ETF, Is basically an index fund. Trades like a closed-end fund (without the discount phenomenon). An area where ETFs seem to have an edge over the more traditional index funds is the more specialized indexes. A well-known ETF is the “Standard and Poor’s Depositary Receipt” or SPDR. This ETF mimics the S&P 500 index. It is commonly called “spider." Another well-known ETF mimics the Dow Jones—it is called "Diamond.” A list of ETFs can be found at www.amex.com. * Exchange Traded Funds, Performance Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * Leveraged ETFs Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson A particularly interesting, but potentially dangerous, ETF growth area is in leveraged ETFs. The fund managers of a leveraged ETF create a portfolio designed to provide a return that tracks the underlying index. But, by also using derivative contracts, the managers can magnify, or leverage, the return on the underlying. The Fund Manager can also use derivatives to generate returns opposite, or inverse, of the index return. Leveraged funds are designed to have twice the return on an index, say the S&P 500. In other words, if the S&P 500 return on a given day is one percent, the leveraged fund should provide a return of two percent. The danger is that leverage works both ways. Losses are also magnified by two. * Leveraged ETFs Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Levered ETFs seem to track their underlying indexes on a short-term basis, i.e., day by day. Over longer periods of time, however, their performance is probably not what you would expect. For example, trading in leveraged ETFs offered by Rydex, a reputable firm, began on November 7, 2007. The Long Fund (RSU) was designed to earn twice the S&P 500 index return. The Inverse Fund (RSW) was designed to earn the opposite of twice the S&P 500 Index return. Over the next two years, the S&P 500 lost -22.4 percent. Given its objective, the RSU fund should have lost -44.8 percent. The inverse fund, RSW, should have gained 44.8 percent. Over this two-year period, however, the RSU lost -56.5 percent, and the inverse fund, the RSW, lost -7.3%. How is such a result possible? * Leveraged ETFs Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The answer lies in average versus geometric returns (and not with Rydex). Recall that geometric returns are lower than arithmetic returns Volatility fuels the difference. Both Rydex leveraged funds add extra volatility to the series of S&P 500 index returns. As a result, returns from any leveraged funds will be less than expected. Example: Consider a week during which the S&P500 earns daily returns of 1, -2, 2, 1, and 3 percent, respectively. The arithmetic average is 1%. The geometric average is just slightly less, 0.986%. This difference seems trivial. Consider the returns, however, for a twice-leveraged fund. The arithmetic average is exactly double, 2%. The geometric average, however, is [(1.02)(0.96)(1.04)(1.02)(1.06)](1/5) – 1 = .0194, or 1.94%. Six basis points tracking error in one week. The longer the holding period and/or the more volatile the underlying index, the less accurate a leveraged fund will be in tracking its stated objective. * Exchange Traded Notes, ETNs Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Introduced in mid-2006 by Barclays Bank. To investors, ETNs look like ETFs. However, ETNs are unsecured debt—so, unlike holders of ETFs, holders of ETNs do have default risk. ETNs provide investors with exposure to commodities, but without the leveraged risk of futures contracts. Handy web source: www.ipathetn.com. * Hedge Funds, Overview Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Like mutual funds, hedge funds collect pools of money from investors. Like mutual funds, hedge funds are generally required to register with the SEC. But: Hedge funds are not required to maintain any particular degree of diversification or liquidity. Hedge fund managers have considerably more freedom to follow various investment strategies, or styles. Investing in hedge funds is not suitable for the all investors. Hedge funds accept only “qualified” (or accredited) investors. To be considered a qualified investor, you need to fulfill one of these conditions: You must be an institution or an individual investor with a net worth of about a million dollars. You must have a recurring annual income of over $200,000. Hedge Fund Fees Most common fee structure is 2/20, but many others exist. A short way to say that the manager charges an annual 2% management fee and retains 20% of the hedge fund profits. To prevent the fund from being manipulated by its managers, many fee structures include hurdles for the manager to meet. A common example is called a “high-water mark.” When a hedge fund fee structure includes a high-water mark, the manager will receive performance fees only when the fund value is higher than its previous highest value. Why do hedge fund investors willingly pay high fees? Obvious answer: returns earned are high enough to provide a reasonable return. Some experts opine that hedge fund returns net of fees are about the same as the overall stock market return. If these experts are correct, why would anyone invest in a hedge fund instead of a market index fund? The answer lies in the principle of diversification. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * Some Common Hedge Fund Investment Styles Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Market Neutral. Goal: offset risk with opposite positions in pairs of securities. These hedge funds are also called long-short funds. Properly constructed, the resulting portfolio makes money regardless of how the overall market performs. Hence the name “market neutral.” Expected Volatility: Low. Arbitrage. Goal: identify a mispricing in relationships between securities that theoretically should not exist. These hedge fund managers look at pricing relationships for securities offered by the same company, or for investments across time or countries. Expected Volatility: Low. Distressed Securities. Goal: Buy securities that are being offered at deep discounts resulting from company-specific or sector-wide distress. For example, a manager of distressed securities fund might buy securities of firms facing bankruptcy. Expected Volatility: Low to moderate. * Some Common Hedge Fund Investment Styles Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Macro. Goal: These hedge fund managers attempt to profit from changes in global economies brought about by governmental policies that affect interest rates interest rates, currencies, or commodity prices. Macro fund managers often use leverage and derivative securities to increase the impact of market moves. Expected Volatility: High. Short Selling. Goal: Managers of a pure short hedge fund only short sell. In addition, these managers use leverage through the use of margin. Expected Volatility: High Market Timing. Goal: Managers of these hedge funds attempt to identify trends in particular sectors or overall global markets. These managers often take concentrated positions and generally use leverage to increase the fund’s exposure to predicted movements. Expected Volatility: High * Hedge Funds Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson As you can see, hedge fund managers employ many approaches, and each has its own risk level. The lesson? Suppose you make your millions and become a qualified hedge fund investor You still have your work cut out trying to identify the best hedge fund for your portfolio. Suppose you just cannot decide? You might want to use a “Fund of Funds.” These investment companies invest in hedge funds. Note: There is an additional, and significant, layer of fees heaped onto the already hefty hedge fund fees. * Registered Retirement Savings Plan (RRSP) Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Every year more and more Canadians choose to invest in registered retirement savings plans as part of their long-term investment portfolios. The registered retirement savings plan is, as its name suggests, a retirement plan. Investors can open an RRSP account and contribute throughout the year. All contributions are tax deductible; thus, investors can use their contributions to these plans to reduce their income taxes. * Registered Retirement Savings Plan (RRSP) Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson As long as their savings stay in the plan, investors do not pay tax. Once they withdraw their money, however, they do pay tax. RRSP funds can be invested in stocks, bonds, and mutual funds. Canadian investors choose mutual funds as the most popular RRSP investment option. * Income Trusts Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Income trusts started in 1985 with gas and oil company trusts and have become very popular in Canada since that time. Recently, Canadian mutual funds have started to invest heavily (similar to individual investors) in income trusts. Income trusts are created as asset-holding entities by companies. A trust creates units and offers these units to the public in exchange for money. Income trusts distribute their earnings as cash flows to the unitholders. Cash distributions are taxed differently from dividends.. Income Trusts pay little or no corporate tax, and distribute the majority of their earnings to their unitholders. This increased demand caused the unit prices to increase further and more and more companies applied to be restructured as income trusts. * Useful Internet Sites Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson www.ici.org (mutual fund facts and figures) www.vanguard.com (example of a major fund family website) www.fidelity.com (website of largest investment advisory firm in US) www.mfea.com (information on thousands of funds) www.morningstar.com (one of the best mutual fund sites) www.domini.com (more “social conscience” funds) www.vicefund.com (“vice” funds) www.ishares.com (more on exchange traded funds) www.ipathetn.com (all about ETNs) www.hedgeworld.com (hedge fund information) www.hedgefundcenter.com (more hedge fund information) * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review Investment Companies and Fund Types Open-End versus Closed-End Funds Net Asset Value Mutual Fund Operations Mutual Fund Organization and Creation Taxation of Investment Companies The Fund Prospectus and Annual Report Mutual Fund Costs and Fees Types of Expenses and Fees Expense Reporting Why Pay Loads and Fees? Short-Term Funds Money Market Mutual Funds Money Market Deposit Accounts * 33 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review Long-Term Funds Stock Funds Taxable and Municipal Bond Funds Stock and Bond Funds Mutual Fund Objectives: Recent Developments Mutual Fund Performance Mutual Fund Performance Information How Useful are Fund Performance Ratings? Closed-End Funds, Exchange Traded Funds, and Hedge Funds Closed-End Funds Performance Information The Closed-End Fund Discount Mystery Exchange Traded Funds Leveraged Funds Exchange Traded Notes Hedge Funds and their Investment Styles * 34 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of Chapter Review Registered Retirement Savings Plan (RRSP) Income Trusts Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Loss) (or Gain Capital Income Dividend Stock a on Return Dollar Total + = Chapter 6 The Stock Market Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * 116 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of Take stock in yourself. Make sure you have a good understanding of: The difference between private and public equity and primary and secondary stock markets. The workings of the New York Stock Exchange. The workings of the Toronto Stock Exchange. How NASDAQ operates. How to calculate index returns. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Our goal in this chapter is to provide a “big picture” overview of: Who owns stocks, How a stock exchange works, and How to read and understand the stock market information reported in the financial press. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Private Equity is used in the rapidly growing area of equity financing for nonpublic companies. Banks are generally not interested in making loans to start-up companies, especially ones : with no assets (other than an idea). run by fledgling entrepreneurs with no track record. Firms with this profile search for venture capital (VC), an important part of the private equity markets. Firms other than start-ups might also need financing. Private equity also includes: middle-market firms large leveraged buyouts Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Private equity funds and hedge funds are two types of investment companies. Both are set up as limited partnerships. pool money from investors. invest this money on behalf of these investors. use, typically, a 2/20 fee structure (i.e., a 2 percent annual management fee and 20 percent of profits). have built-in constraints to prevent managers from taking excessive compensation. Private equity funds generally have: a high-water-mark provision a “clawback” provision Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Venture Capital refers to financing new, often high-risk, start-ups. Individual venture capitalists invest their own money. Venture capital firms pool funds from various sources, like Individuals Pension funds Insurance companies Large corporations University endowments Venture capitalists know that many new companies will fail. The companies that succeed can provide enormous profits. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * To limit their risk: Venture capitalists generally provide financing in stages. Venture capitalists actively help run the company. At each stage, enough money is invested to reach the next stage. Ground-floor financing Mezzanine Level financing At each stage of financing, the value of the founder’s stake grows and the probability of success rises. If goals are not met, the venture capitalists withhold further financing. If a start-up succeeds: The big payoff frequently comes when the company is sold to another company or goes public. Either way, investment bankers are often involved in the process. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Many small, regional private equity funds concentrate their investments in “middle market” companies. ongoing concerns (i.e., not start-ups) known performance history typically, small and family owned and operated. Reasons middle market companies seek more capital Expansion beyond their existing region Founder wants to “cash out” A private equity fund might purchase a portion of the business so that others can now manage the company. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Suppose a company (or someone else) purchases all the shares of the company held by the public at large? This process is called “taking the company private.” The cost of going private is often high. A manager or investor who wants to take a company private probably needs to borrow a significant amount of money. Taking a company private is called a leveraged buyout (LBO). LBO market activity levels depend on credit markets. Around 2005, the LBO market was quite active. Activity in the LBO market came to a standstill after the crash of 2008. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson The primary market is the market where investors purchase newly issued securities. Initial public offering (IPO): An IPO occurs when a company offers stock for sale to the public for the first time. Seasoned equity offering (SEO): If a company already has public shares, an SEO occurs when a company raises more equity. The secondary market is the market where investors trade previously issued securities. An investor can trade: Directly with other investors. Indirectly through a broker who arranges transactions for others. Directly with a dealer who buys and sells securities from inventory. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Primary Market: “New-car with sticker still in window”; Secondary Market: “Used car market” An IPO (and an SEO) involves several steps. Company appoints an investment banking firm to arrange financing. Investment banker designs the stock issue and arranges for fixed commitment or best effort underwriting. Company prepares a prospectus (usually with outside help) and submits it to the Securities and Exchange Commission (SEC) for approval. Investment banker circulates preliminary prospectus (red herring). Upon obtaining SEC approval, company finalizes prospectus. Underwriters place announcements (tombstones) in newspapers and begin selling shares. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * The goal of a secondary market is to match investors wishing to buy stocks with investors wishing to sell stocks. Common stock trading typically occurs on either an organized stock exchange or a trading network. Important concepts: The bid price: The price dealers pay investors. The price investors receive from dealers. The ask price: The price dealers receive from investors. The price investors pay dealers. The difference between the bid and ask prices is called the bid-ask spread, or simply the spread. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * The New York Stock Exchange (NYSE), popularly known as the Big Board, celebrated its bicentennial in 1992. The NYSE has occupied its current building on Wall Street since the early 1900’s. For 200 years, the NYSE was a not-for-profit New York State corporation. The NYSE went public in 2006 NYSE Group, Inc., ticker: NYX Naturally, NYX stock is listed on the NYSE In 2007, NYSE Group merged with Euronext to form NYSE Euronext, the world’s largest exchange. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Historically, the NYSE had 1,366 exchange members. These members: Were said to own “seats” on the exchange. Collectively owned the exchange, although professionals managed the exchange. Regularly bought and sold seats (Record seat price: $3 million in 2005) Seat holders could buy and sell securities on the exchange floor without paying commissions. In 2006, all of this changed when the NYSE went public. Instead of purchasing seats, exchange members purchase trading licenses: number limited to 1,500 In 2010, a license would set you back a cool $40,000—per year. Having a license entitles the holder to buy and sell securities on the floor of the exchange. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * For a long time, most securities listed at the NYSE were divided among specialists—an exclusive dealer, or intermediary, for a set of securities. Specialists: posted bid prices and ask prices for each security assigned to them. were obligated to make and maintain a fair, orderly market Specialists stood ready to buy at bid prices and sell at ask prices when outside sell and buy order flows were unequal Specialists had an exclusive, advance look at incoming orders flowing to the display book. Because of this advance look, specialists had an information advantage when they were making quotes and matching orders. Under this system, specialists, however, could “work” orders, that is, try to improve trading prices for customers. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson In 2009, aiming to stay competitive, the NYSE replaced the role of specialists with two classes of market makers: designated market makers (DMMs) and supplemental liquidity providers (SLPs). What were specialists are now the DMMs. The DMMs are assigned a set of securities and are obligated to maintain a fair and orderly market in these stocks Differences between the Specialist Role and the DMM Role DDMs can compete against other exchange members for trades. Specialists had to step back from a trade if a floor broker order had the same price. Unlike the former specialist system, however, DMMs do not receive an advance look at incoming orders. DMMs do not have an exclusive right to make markets in their assigned securities. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson The largest number of NYSE members are registered as commission brokers. Commission brokers execute customer orders to buy and sell stocks. When commission brokers are too busy, they may delegate some orders to floor brokers, or two-dollar brokers, for execution. A small number of NYSE members are floor traders, who independently trade for their own accounts. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * In 2008, the total number of companies listed on the NYSE represented a total global market value of about $16.7 trillion. Initial and annual listing fees are charged based on the number of shares. To apply for listing, companies have to meet certain minimum requirements with respect to: The number of shareholders Trading activity The number and value of shares held in public hands Annual earnings Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * The Toronto Stock Exchange (TSX), unlike the NYSE, is a computerized exchange. In 2002, the Toronto Stock Exchange celebrated its 150th birthday having started its operations in 1861 with 18 securities and 14 member firms. In 1861, approximately twenty-five businessmen decided to form a stock exchange in Toronto in their meeting at Toronto’s Masonic Temple. At that time, members paid $250 to purchase a seat. In 1901, the price of membership had risen to $12,000 and trading volume became approximately 1 million shares per year. The Toronto Stock Exchange experienced solid growth and became the third largest North American exchange in the 1940s. By 1955 a membership seat cost $100,000 and trading volume reached 1 billion shares. In 1977, the Toronto Stock Exchange introduced the world’s first Computer Assisted Trading System (CATS) and closed its trading floor to become the largest electronic North American Exchange. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson The Toronto Stock Exchange, with Canadian exchange restructuring in 1999, became the major stock exchange for trading senior equities. Canadian derivatives trading were transferred to the Montreal Exchange. The Vancouver and Alberta Exchanges merged to become the Canadian Venture Exchange (CDNX). Later the TSX purchased the CDNX and called it the TSX Venture Exchange. In 2008, the shareholders of the TSX group decided to change the name of the company from TSX Group to TMX Group. According to market capitalization, the TSX group is the third largest exchange in North America and the seventh largest exchange in the world. As of 2009, there are 3,640 listed issuers in TSX and TSXV(Toronto Venture Exchange), and the TMX group is second in the world for number of listed issuers. There are 281 international issuers and 302new listings. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Currently the TMX Group is the leader exchange in oil and gas sector. The TMX group is the global leader in mining industry as well. The highest number of mining companies are listed at the TSX and TSXV. The total number of the listed companies is 1531. In 2010, the trading volume related to mining industry exceeded 91 billion Canadian Dollar. In February 2011, the TMX announced that they are evaluating a merger with the London Stock Exchange. If the merger would have been approved by the authorities the new exchange would have become the third largest exchange in the world. However, later in the year the group rejected the offer and began negotiating an offer by the Maple Group( a group of Canadian banks and the firms. Today the TSX has over 100 participating organizations and member firms. These organizations help companies in underwriting their new issues, in listing and in providing corporate financial services. Different customer orders (market, limit or stop orders) are entered into the system by these organizations. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * The name “NASDAQ” is derived from the acronym NASDAQ, which stands for National Association of Securities Dealers Automated Quotations system. NASDAQ is now a proper name in its own right. Introduced in 1971, the NASDAQ market is a computer network of securities dealers who disseminate timely security price quotes to NASDAQ subscribers. The NASDAQ has more companies listed than the NYSE. On most days, volume on the NASDAQ exceeds the NYSE volume. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * The third market is an off-exchange market for securities listed on an organized exchange. The fourth market is for exchange-listed securities in which investors trade directly with one another, usually through a computer network. For dually listed stocks, regional exchanges also attract substantial trading volume. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * There are essentially four differences between the stock indexes them: (1) the market covered; (2) the types of stocks included; (3) how many stocks are included; and (4) how the index is calculated. The first three differences are straightforward. Some indexes such as the S&P/TSX Energy Index, focus on specific industries. Others, such as the S&P/TSX Composite , focus on particular markets. Some have a small number of stocks, like the S&P/TSX 60 which contains only 60 stocks. Some indexes contain small companies, like the S&P/TSX Cdn Small Cap. How stock market indexes are computed is not quite so straightforward, but it is important to understand. There are two major types of stock market index: price-weighted and value-weighted. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson The most widely followed barometer of day-to-day stock market activity is the Dow Jones Industrial Average (DJIA), or “Dow” for short. The DJIA is an index of the stock prices of 30 large companies representative of American industry. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Indexes can be distinguished in four ways: The market covered, The types of stocks included, How many stocks are included, and How the index is calculated (price-weighted, e.g. DJIA, versus value-weighted, e.g. S&P 500). Stocks that do not trade during a time period cause index staleness over that time period. That is, we do not know the "true" index level if all the stock prices are not updated, i.e., fresh. Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * For a value-weighted index (i.e., the S&P 500, S&P/TSX Composite), companies with larger market values have higher weights. For a price-weighted index (i.e., the DJIA), higher priced stocks receive higher weights. This means stock splits cause issues. But, stock splits can be addressed by adjusting the index divisor. Note: As of April 12, 2010, the DJIA divisor was a nice “round” 0.132319125! Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Note: Shares = $1,000,000 / 131.130 = 7,626 Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Sheet1 Price Shares Company Price Weight to Buy Boeing 67.50 0.5148 7,626 Nordstrom 41.93 0.3198 7,626 Lowe's 21.70 0.1655 7,626 131.130 1.000 7,626 What would have happened to the divisor if Home Depot shares were selling at $65.72 per share instead of $32.90? Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Sheet1 Day 1 of Index: Company Price Boeing 67.50 Nordstrom 41.93 Lowe's 21.70 Sum: 131.13 Index: 43.71 (Divisor = 3) Before Day 2 starts, you want to replace Lowe's with Home Depot, selling at $32.90. To keep the value of the Index the same, i.e., 43.71: Boeing 67.50 Nordstrom 41.93 Home Depot 32.90 Sum: 142.33 142.33 / Divisor = 43.71, if Divisor is: 3.2562342713 Note: Shares to Buy = $1,000,000*Weight / Price Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Sheet1 Total Market Market- Market- Shares Capitalization Value Shares Company Price (millions) (millions) Weight to Buy Boeing 67.50 732.74 49,460.0 0.5550 8,223 Nordstrom 41.93 219.65 9,210.0 0.1034 2,465 Lowe's 21.70 1,402.76 30,440.0 0.3416 15,742 Total: 131.130 Total: 89,110.0 1.0000 26,430 Using the Portfolio from Example III: Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Sheet1 Total Shares Market Capitalization Day 1: Company Price (millions) (millions) Boeing 67.50 732.74 49,460 Nordstrom 41.93 219.65 9,210 Lowe's 21.70 1402.76 30,440 Total MV(1): 89,110 Divisor (Set by Vendor): 89.11 Day 1 Index Level: 1,000.00 Total Shares Market Capitalization Day 2: Company Price (millions) (millions) Boeing 69.00 732.74 50,559 Nordstrom 41.93 219.65 9,210 Lowe's 21.70 1402.76 30,440 Total MV(2): 90,209 Day 2 Index Level: 1,012.33 Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Sheet1 Total Shares Market Capitalization Day 3: Company Price (millions) (millions) Boeing 71.10 732.740 52,098 Nordstrom 41.93 219.650 9,210 Lowe's 21.70 1,402.760 30,440 Total MV(3): 91,748 Total MV(2): 90,209 Day 2 Index Level: 1,012.33 Day 3 Index Level: 1,029.60 Total MV(1): 89,110 Day 3 Index Level: 1,029.60 www.hoovers.com (information on Initial Public Offerings, or IPOs) www.nyse.com (website for the New York Stock Exchange) www.tmx.com (website for the Toronto Stock Exchange) www.nasdaq.com (website for the NASDAQ) averages.dowjones.com (The Dow Jones Industrial Average) www.russell.com (the Russell Indexes) www.barra.com (reference for “value” and “growth” indexes) www.djindexes.com (reference for current divisor for the DIJA) www.standardandpoors.com (website for S&P 500) www.nni.nikkei.co.jp (website for Japan’s Nikkei 225 index) Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Private and Public Equity Private Equity Funds The Primary and Secondary Stock Markets The Primary Market for Common Stock The Secondary Market for Common Stock Dealers and Brokers The New York Stock Exchange NYSE-Listed Stocks Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * Toronto and Toronto Venture Exchange NYSE and NASDAQ Competitors Stock Market Information Stock Market Indexes More on Price-Weighted Indexes Value-Weighted Indexes Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * PriceShares CompanyPriceWeightto Buy Boeing67.500.51487,626 Nordstrom41.930.31987,626 Lowe's21.700.16557,626 131.1301.0007,626 Day 1 of Index:CompanyPrice Boeing67.50 Nordstrom41.93 Lowe's21.70 Sum:131.13 Index: 43.71 (Divisor = 3) Before Day 2 starts, you want to replace Lowe's with Home Depot, selling at $32.90. To keep the value of the Index the same, i.e., 43.71: Boeing67.50 Nordstrom41.93 Home Depot32.90 Sum:142.33 142.33 / Divisor = 43.71, if Divisor is:3.256234271 SharesCapitalizationValueShares CompanyPrice(millions)(millions)Weightto Buy Boeing67.50732.7449,460.00.55508,223 Nordstrom41.93219.659,210.00.10342,465 Lowe's21.701,402.7630,440.00.341615,742 Total:131.130Total:89,110.01.000026,430 Lowe's21.701402.7630,440 Total MV(1):89,110 Divisor (Set by Vendor):89.11 Day 1 Index Level:1,000.00 Total SharesMarket Capitalization Day 2:CompanyPrice(millions)(millions) Boeing69.00732.7450,559 Nordstrom41.93219.659,210 Lowe's21.701402.7630,440 Total MV(2):90,209 Day 2 Index Level:1,012.33 Total SharesMarket Capitalization Day 3:CompanyPrice(millions)(millions) Boeing71.10732.74052,098 Nordstrom41.93219.6509,210 Lowe's21.701,402.76030,440 Total MV(3):91,748 Total MV(2):90,209 Day 2 Index Level:1,012.33 Day 3 Index Level:1,029.60 Total MV(1):89,110 Day 3 Index Level:1,029.60 1 Day Level Index 1 Day Value Market 3 Day Value Market Index 3 Day or 2 Day Level Index 2 Day Value Market 3 Day Value Market Index 3 Day ´ = ´ = * Chapter 7 Brief History of Risk and Return Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * 1 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Learning Objectives Separate yourself from the commoners by having a good understanding of these security valuation methods: 1. The basic dividend discount model. 2. The two-stage dividend growth model. 3. The residual income model and free cash flow model. 4. Price ratio analysis. * * * * Common Stock Valuation Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Our goal in this chapter is to examine the methods commonly used by financial analysts to assess the economic value of common stocks. These methods are grouped into four categories: Dividend discount models Residual Income model Free Cash Flow model Price ratio models * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Security Analysis: Be Careful Out There Fundamental analysis is a term for studying a company’s accounting statements and other financial and economic information to estimate the economic value of a company’s stock. The basic idea is to identify “undervalued” stocks to buy and “overvalued” stocks to sell. In practice however, such stocks may in fact be correctly priced for reasons not immediately apparent to the analyst. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Dividend Discount Model The Dividend Discount Model (DDM) is a method to estimate the value of a share of stock by discounting all expected future dividend payments. The basic DDM equation is: In the DDM equation: P0 = the present value of all future dividends Dt = the dividend to be paid t years from now k = the appropriate risk-adjusted discount rate * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Dividend Discount Model Suppose that a stock will pay three annual dividends of $200 per year, and the appropriate risk-adjusted discount rate, k, is 8%. In this case, what is the value of the stock today? * * * * The Dividend Discount Model: The Constant Growth Rate Model Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Assume that the dividends will grow at a constant growth rate g. The dividend in the next period, (t + 1), is: For constant dividend growth for “T” years, the DDM formula becomes: * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Constant Growth Rate Model Suppose the current dividend is $10, the dividend growth rate is 10%, there will be 20 yearly dividends, and the appropriate discount rate is 8%. What is the value of the stock, based on the constant growth rate model? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Dividend Discount Model: The Constant Perpetual Growth Model Assuming that the dividends will grow forever at a constant growth rate g. For constant perpetual dividend growth, the DDM formula becomes: * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Constant Perpetual Growth Model Think about the electric utility industry. In 2009, the dividend paid by the utility company, DTE Energy Co. (DTE), was $2.12. Using D0 =$2.12, k = 5.75%, and g = 2%, calculate an estimated value for DTE. Note: the actual mid-2009 stock price of DTE was $40.29. What are the possible explanations for the difference? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Dividend Discount Model: Estimating the Growth Rate The growth rate in dividends (g) can be estimated in a number of ways: Using the company’s historical average growth rate. Using an industry median or average growth rate. Using the sustainable growth rate. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Historical Average Growth Rate Suppose the Broadway Joe Company paid the following dividends: 2005: $1.50 2008: $1.80 2006: $1.70 2009: $2.00 2007: $1.75 2010: $2.20 The spreadsheet below shows how to estimate historical average growth rates, using arithmetic and geometric averages. * Sheet1 Year: Dividend: Pct. Chg: 2010 $2.20 10.00% 2009 $2.00 11.11% 2008 $1.80 2.86% Grown at 2007 $1.75 2.94% Year: 7.96%: 2006 $1.70 13.33% 2005 $1.50 2005 $1.50 2006 $1.62 2007 $1.75 Arithmetic Average: 8.05% 2008 $1.89 2009 $2.04 Geometric Average: 7.96% 2010 $2.20 * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Sustainable Growth Rate Return on Equity (ROE) = Net Income / Equity Payout Ratio = Proportion of earnings paid out as dividends Retention Ratio = Proportion of earnings retained for investment * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Calculating and Using the Sustainable Growth Rate In 2009, American Electric Power (AEP) had an ROE of 10%, projected earnings per share of $2.90, and a per-share dividend of $1.64. What was AEP’s: Retention rate? Sustainable growth rate? Payout ratio = $1.64 / $2.90 = .566 or 56.6% So, retention ratio = 1 – .566 = .434 or 43.4% Therefore, AEP’s sustainable growth rate = .10  .434 = .0434, or 4.34% * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Calculating and Using the Sustainable Growth Rate What is the value of AEP stock using the perpetual growth model and a discount rate of 5.75%? The actual late-2009 stock price of AEP was $31.83. In this case, using the sustainable growth rate to value the stock gives a reasonably poor estimate. What can we say about g and k in this example? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Analyzing ROE To estimate a sustainable growth rate, you need the (relatively stable) dividend payout ratio and ROE. Changes in sustainable growth rate likely stem from changes in ROE. The DuPont formula separates ROE into three parts (profit margin, asset turnover, equity multiplier) Managers can increase the sustainable growth rate by: Decreasing the dividend payout ratio Increasing profitability (Net Income / Sales) Increasing asset efficiency (Sales / Assets) Increasing debt (Assets / Equity) * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Two-Stage Dividend Growth Model The two-stage dividend growth model assumes that a firm will initially grow at a rate g1 for T years, and thereafter, it will grow at a rate g2 < k during a perpetual second stage of growth. The Two-Stage Dividend Growth Model formula is: * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Using the Two-Stage Dividend Growth Model Although the formula looks complicated, think of it as two parts: Part 1 is the present value of the first T dividends (it is the same formula we used for the constant growth model). Part 2 is the present value of all subsequent dividends. So, suppose MissMolly.com has a current dividend of D0 = $5, which is expected to shrink at the rate, g1 = 10%, for 5 years but grow at the rate, g2 = 4%, forever. With a discount rate of k = 10%, what is the present value of the stock? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Using the Two-Stage Dividend Growth Model The total value of $46.03 is the sum of a $14.25 present value of the first five dividends, plus a $31.78 present value of all subsequent dividends. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth Chain Reaction, Inc., has been growing at a phenomenal rate of 30% per year. You believe that this rate will last for only three more years. Then, you think the rate will drop to 10% per year. Total dividends just paid were $5 million. The required rate of return is 20%. What is the total value of Chain Reaction, Inc.? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth First, calculate the total dividends over the “supernormal” growth period: Using the long run growth rate, g, the value of all the shares at Time 3 can be calculated as: P3 = [D3 x (1 + g)] / (k – g) P3 = [$10.985 x 1.10] / (0.20 – 0.10) = $120.835 Year Total Dividend: (in $millions) 1 $5.00 x 1.30 = $6.50 2 $6.50 x 1.30 = $8.45 3 $8.45 x 1.30 = $10.985 * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth To determine the present value of the firm today, we need the present value of $120.835 and the present value of the dividends paid in the first 3 years: If there are 20 million shares outstanding, the price per share is $4.38. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The H-Model For Chain Reaction, Inc., we assumed a supernormal growth rate of 30 percent per year for three years, and then growth at a perpetual 10 percent. The growth rate is more likely to start at a high level and then fall over time until reaching its perpetual level. Many possible ways to assume how the growth rate declines A popular way is the H-model: which assumes a linear growth rate decline * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The H-Model Let’s revisit Chain Reaction, Inc. Suppose the growth rate begins at 30% and reaches 10% in year 4 and beyond. Using the H-model, we would assume that the company’s growth rate would decline by 20% from the end of year 1 to the beginning of year 4. If we assume a linear decline: the growth rate falls by 6.67% per year (20%/3 years). Growth estimates would be: 30%, 23.33%, 16.66%, and 10% Using these growth estimates, you will find that the firm value is $75.93 million, or $3.80 per share. The value is lower than before because of the lower growth rates in years 2 and 3. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Discount Rates for Dividend Discount Models The discount rate for a stock can be estimated using the capital asset pricing model (CAPM ). We will discuss the CAPM in a later chapter. However, we can estimate the discount rate for a stock using this formula: Discount rate = time value of money + risk premium = U.S. T-bill Rate + (Stock Beta x Stock Market Risk Premium) T-bill Rate: return on 90-day U.S. T-bills Stock Beta: risk relative to an average stock Stock Market Risk Premium: risk premium for an average stock * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Observations on Dividend Discount Model Constant Perpetual Growth Model: Simple to compute Not usable for firms that do not pay dividends Not usable when g > k
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.
Constant perpetual growth is often an unrealistic assumption.

*
*
Observations on Dividend Discount Models
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Two-Stage Dividend Growth Model:
More realistic in that it accounts for two stages of growth
Usable when g > k in the first stage
Not usable for firms that do not pay dividends
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.

We have valued only companies that pay dividends.
But, there are many companies that do not pay dividends.
What about them?
It turns out that there is an elegant way to value these companies, too.
The model is called the Residual Income Model (RIM).
Major Assumption (known as the Clean Surplus Relationship, or CSR): The change in book value per share is equal to earnings per share minus dividends.

Inputs needed:
Earnings per share at time 0, EPS0
Book value per share at time 0, B0
Earnings growth rate, g
Discount rate, k
There are two equivalent formulas for the Residual Income Model:
BTW, it turns out that the RIM is mathematically the same as the constant perpetual growth model.

Duckwall—Alco Stores, Inc. (DUCK)
It is July 1, 2010—shares are selling in the market for $10.94.
Using the RIM:
EPS0 = $1.20
DIV = 0
B0 = $5.886
g = 0.09
k = .13

What can we say
about the market
price of DUCK?

Using the information from the previous slide, what growth rate results in a DUCK price of $10.94?

We can value companies that do not pay dividends using the residual income model.
Note: We assume positive earnings when we use the residual income model.
But, there are companies that do not pay dividends and have negative earnings.
Negative earnings = little value?
We calculate earnings based on accounting rules and tax codes.
It is possible that a company has:
negative earnings
positive cash flows
a positive value.

Depreciation—the key to understand how a company can have negative earnings and positive cash flows
Depreciation reduces earnings because it is counted as an expense (more expenses = lower taxes paid).
Most stock analysts, however, use a relatively simple formula to calculate Free Cash Flow, FCF:

FCF = Net Income + Depreciation – Capital Spending
We can see that it is possible for: Net Income < 0 and FCF > 0
Depreciation and Capital Spending matter in FCF.

The DDMs calculate a value of the equity only.
DDMs use dividends, a cash flow only to equity holders
DDMs use the CAPM to estimate required return
DDMs use an equity beta to account for risk
Using the FCF model, we calculate a value for the firm.
Free cash flow can be paid to debt holders and to stockholders.
We can still calculate the value of equity using FCF
Calculate the value of the entire firm
Subtract out the value of debt
We need a beta for assets, not the equity, to account for risk

*
*
Asset Betas
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Asset betas measure the risk of the company’s industry.
Firms in an industry should have about the same asset betas.
Their equity betas, however, could be quite different.
Investors can increase portfolio risk by using margin (i.e., borrowing money to buy stock).
A business can increase risk by using debt.
So, to value the company, we must “convert” reported equity betas into asset betas by adjusting for leverage.
The following conversion formula is widely used:

What happens when a firm has no debt?
tax rate.

*
*
The FCF Approach, Example
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Inputs
An estimate of FCF:
Net Income
Depreciation
Capital Expenditures
The growth rate of FCF
The proper discount rate
Tax rate
Debt/Equity ratio
Equity beta
Calculate value using a “DDM” formula
“DDM” because we are using FCF, not dividends.

*
*
Valuing Landon Air: A New Airline
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
An estimate of FCF:
Net Income: $25 million
Depreciation: $10 million
Capital Expenditures: $3 million
Growth rate of FCF: 3%
Tax rate: 35%
Debt/Equity ratio: .40
Equity beta: 1.2

Asset Beta:
1.2 = BAsset x [1+.4 x (1-.35)]
1.2 = BAsset x 1.26
BAsset = 0.95
The proper discount rate: k = 4.00 + (7.00 × 0.95) = 10.65%
Assume:
No dividends
Risk-free rate = 4%
Market risk premium = 7%

Price-earnings ratio (P/E ratio)
Current stock price divided by annual earnings per share (EPS)
Earnings yield
Inverse of the P/E ratio: earnings divided by price (E/P)
High-P/E stocks are often referred to as growth stocks, while low-P/E stocks are often referred to as value stocks.

Price-cash flow ratio (P/CF ratio)
Current stock price divided by current cash flow per share
In this context, cash flow is usually taken to be net income plus depreciation.
Most analysts agree that in examining a company’s financial performance, cash flow can be more informative than net income.
Earnings and cash flows that are far from each other may be a signal of poor quality earnings.

Price-sales ratio (P/S ratio)
Current stock price divided by annual sales per share
A high P/S ratio suggests high sales growth, while a low P/S ratio suggests sluggish sales growth.
Price-book ratio (P/B ratio)
Market value of a company’s common stock divided by its book (accounting) value of equity
A ratio bigger than 1.0 indicates that the firm is creating value for its stockholders.

*
*
Price/Earnings Analysis, Intel Corp.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Intel Corp (INTC) – Earnings (P/E) Analysis
5-year average P/E ratio 20.96
Current EPS $.92
EPS growth rate 8.5%
Expected stock price = historical P/E ratio  projected EPS
$20.92 = 20.96  ($.92  1.085)

Late-2009 stock price = $19.40

*
*
Price/Cash Flow Analysis, Intel Corp.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Intel Corp (INTC) – Cash Flow (P/CF) Analysis
5-year average P/CF ratio 10.85
Current CFPS $1.74
CFPS growth rate 7.5%
Expected stock price = historical P/CF ratio  projected CFPS
$20.29 = 10.85  ($1.74  1.075)
Late-2009 stock price = $19.40

*
*
Price/Sales Analysis, Intel Corp.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
Intel Corp (INTC) – Sales (P/S) Analysis
5-year average P/S ratio 3.14
Current SPS $6.76
SPS growth rate 7%
Expected stock price = historical P/S ratio  projected SPS
$22.71 = 3.14  ($6.76  1.07)

Late-2009 stock price = $19.40

*
*
An Analysis of the McGraw-Hill Company
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
The next few slides contain a financial analysis of the McGraw-Hill Company, using data from the Value Line Investment Survey.

*
The McGraw-Hill Company Analysis, III

Based on the CAPM, k = 4.0% + (1.2  7%) = 12.4%
Retention ratio = 1 – $.90/$2.55 = .65
Sustainable g = .65  36.5% = 23.73%

(Value Line reports a projected ROE of 36.5%)
Because g > k, the constant growth rate model cannot be used. (We would get a value of -$9.83 per share)
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson

*
The McGraw-Hill Company Analysis
(Using the Residual Income Model)

Let’s assume that “today” is January 1, 2010, g = 8.5%, and k = 12.4%.
Using the Value Line Investment Survey (VL), we can fill in column two (VL) of the table below.
We use column one and our growth assumption for column three (CSR) of the table below.
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
End of 2009 2010 (VL) 2010 (CSR)
Beginning BV per share NA $5.95 $5.95
EPS $2.30 $2.55 $2.4955
DIV $.90 $.90 $1.9897
Ending BV per share $5.95 $7.05 $6.4558

Using the CSR assumption:

Using Value Line numbers for EPS1=$2.55, B1=$7.05
B0=$5.95; and using the actual change in book value instead of an estimate of the new book value, (i.e., B1-B0 is = B0 x k)
Stock price at the time = $28.73.
What can we say?

www.nyssa.org (The New York Society of Security Analysts)

www.aaii.com (The American Association of Individual Investors)

www.valueline.com (the home of the Value Line Investment Survey)
Websites for some companies analyzed in this chapter:

www.aep.com

www.intel.com

www.mcgraw-hill.com

Security Analysis: Be Careful Out There

The Dividend Discount Model
Constant Dividend Growth Rate Model
Constant Perpetual Growth
Applications of the Constant Perpetual Growth Model
The Sustainable Growth Rate
The Two-Stage Dividend Growth Model
Discount Rates for Dividend Discount Models
Observations on Dividend Discount Models

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

Residual Income Model (RIM)
Free Cash Flow Model

Price Ratio Analysis
Price-Earnings Ratios
Price-Cash Flow Ratios
Price-Sales Ratios
Price-Book Ratios
Applications of Price Ratio Analysis
An Analysis of the McGraw-Hill Company

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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Chg: 2010$2.2010.00% 2009$2.0011.11% 2008$1.802.86%Grown at 2007$1.752.94%Year:7.96%: 2006$1.7013.33%2005$1.50 2005$1.502006$1.62 2007$1.75 8.05%2008$1.89 2009$2.04 7.96%2010$2.20 Arithmetic Average: Geometric Average: Ratio) Payout - (1 ROE Ratio Retention ROE Rate Growth e Sustainabl ´ = ´ = ( ) $121.36 .0434 .0575 1.0434 $1.64 P = - ´ = 0 Equity Assets Assets Sales Sales Income Net ROE Equity Income Net ´ ´ = = 2 2 0 T 1 T 1 1 1 0 g k ) g (1 D k 1 g 1 k 1 g 1 1 g k ) g (1 D P - + ÷ ø ö ç è æ + + + ú ú û ù ê ê ë é ÷ ø ö ç è æ + + - - + = 0 $46.03. $31.78 $14.25 0.04 0.10 0.04) $5.00(1 0.10 1 0.90 0.10 1 0.90 1 0.10) ( 0.10 ) $5.00(0.90 P g k ) g (1 D k 1 g 1 k 1 g 1 1 g k ) g (1 D P 5 5 2 2 0 T 1 T 1 1 1 0 = + = - + ÷ ø ö ç è æ + + ú ú û ù ê ê ë é ÷ ø ö ç è æ + - - - = - + ÷ ø ö ç è æ + + + ú ú û ù ê ê ë é ÷ ø ö ç è æ + + - - + = 0 0 ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) million. $87.58 $69.93 $6.36 $5.87 $5.42 0.20 1 $120.835 0.20 1 $10.985 0.20 1 $8.45 0.20 1 $6.50 P k 1 P k 1 D k 1 D k 1 D P 3 3 2 3 3 3 3 2 2 1 = + + + = + + + + + + + = + + + + + + + = 0 0 g k g B EPS P or g k k B g) (1 EPS B P 0 1 0 0 0 0 0 - ´ - = - ´ - + + = $19.46. .04 $.7652 $1.308 $5.886 P .09 .13 .13 $5.886 .09) (1 $1.20 $5.886 P g k k B g) (1 EPS B P 0 0 0 0 0 0 = - + = - ´ - + ´ + = - ´ - + ´ + = 3.55%. or .0355 g 6.254g .2222 .4348 1.20g 5.054g $.6570 .7652 1.20g 1.20 g) (.13 $5.054 g .13 .13 $5.886 g) (1 $1.20 $5.886 $10.94 g k k B g) (1 EPS B P 0 0 0 0 = = + = - - + = - ´ - ´ - + ´ + = - ´ - + ´ + = )] (1 Equity Debt [1 Asset Equity t B B - + ´ = shares. of number / million $330.85 share per Value million. $330.85 is equity the of value the debt, in $100 has Air Landon If million $430.85 .03 - .1065 (1.03) 3) - 10 (25 Value Air Landon : DDM Basic Using = = ´ + = 1.085 2.30 ´ 1.085 5.95 ´ 5.95) - (6.4558 - 2.4955 Plug" " = $51.02. P .085 .124 .124 $5.95 .085) (1 $2.30 $5.95 P g k k B g) (1 EPS B P 0 0 0 0 0 0 = - ´ - + ´ + = - ´ - + ´ + = $43.13 P .085 .124 5.95) - ($7.05 $2.55 $5.95 P g k k B g) (1 EPS B P 0 0 0 0 0 0 = - - + = - ´ - + ´ + = * Chapter 8 Stock Price Behaviour and Market Efficiency Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * 1 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Learning Objectives You should strive to have your investment knowledge fully reflect: 1. The foundations of market efficiency. 2. The implications of the forms of market efficiency. 3. Market efficiency and the performance of professional money managers. 4. What stock market anomalies, bubbles, and crashes mean for market efficiency. 5. Tests of Market Efficiency * * * * The Market Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson “A market is the combined behavior of thousands of people responding to information, misinformation, and whim.” “If you want to know what's happening in the market, ask the market.” * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Controversy, Intrigue, and Confusion We begin by asking a basic question: Can you, as an investor, consistently “beat the market?” It may surprise you to learn that evidence strongly suggests that the answer to this question is “probably not.” We show that even professional money managers have trouble beating the market. At the end of the chapter, we describe some market phenomena that sound more like carnival side shows, such as “the amazing January effect.” * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Market Efficiency The efficient market hypothesis (EMH) is a theory that asserts: As a practical matter, the major financial markets reflect all relevant information at a given time. Market efficiency research examines the relationship between stock prices and available information. The important research question: is it possible for investors to “beat the market?” Prediction of the EMH theory: if a market is efficient, it is not possible to “beat the market” (except by luck). * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson What Does “Beat the Market” Mean? The excess return on an investment is the return in excess of that earned by other investments that have the same risk. “Beating the market” means consistently earning a positive excess return. * * * * Three Economic Forces that Can Lead to Market Efficiency Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Investors use their information in a rational manner. Rational investors do not systematically overvalue or undervalue financial assets. If every investor always makes perfectly rational investment decisions, it would be very difficult to earn an excess return. There are independent deviations from rationality. Suppose that many investors are irrational. The net effect might be that these investors cancel each other out. So, irrationality is just noise that is diversified away. What is important here is that irrational investors have different beliefs. Arbitrageurs exist. Suppose collective irrationality does not balance out. Suppose there are some well-capitalized, intelligent, and rational investors. If rational traders dominate irrational traders, the market will still be efficient. These conditions are so powerful that any one of them leads to efficiency. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Forms of Market Efficiency A Weak-form Efficient Market is one in which past prices and volume figures are of no use in beating the market. If so, then technical analysis is of little use. A Semistrong-form Efficient Market is one in which publicly available information is of no use in beating the market. If so, then fundamental analysis is of little use. A Strong-form Efficient Market is one in which information of any kind, public or private, is of no use in beating the market. If so, then “inside information” is of little use. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Information Sets for Market Efficiency * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Why Would a Market be Efficient? The driving force toward market efficiency is simply competition and the profit motive. Even a relatively small performance enhancement can be worth a tremendous amount of money (when multiplied by the dollar amount involved). This creates incentives to unearth relevant information and use it. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Some Implications of Market Efficiency: Does Old Information Help Predict Future Stock Prices? This is a surprisingly difficult question to answer clearly. Researchers have used sophisticated techniques to test whether past stock price movements help predict future stock price movements. Some researchers have been able to show that future returns are partly predictable by past returns. BUT: there is not enough predictability to earn an excess return. Also, trading costs swamp attempts to build a profitable trading system built on past returns. Result: buy-and-hold strategies involving broad market indexes are extremely difficult to outperform. Technical Analysis implication: No matter how often a particular stock price path has related to subsequent stock price changes in the past, there is no assurance that this relationship will occur again in the future. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Some Implications of Market Efficiency: Random Walks and Stock Prices If you were to ask people you know whether stock market prices are predictable, many of them would say yes. To their surprise, and perhaps yours, it is very difficult to predict stock market prices. In fact, considerable research has shown that stock prices change through time as if they are random. That is, stock price increases are about as likely as stock price decreases. When there is no discernable pattern to the path that a stock price follows, then the stock’s price behavior is largely consistent with the notion of a random walk. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Random Walks and Stock Prices, Illustrated * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson How New Information Gets into Stock Prices In its semi-strong form, the EMH states simply that stock prices fully reflect publicly available information. Stock prices change when traders buy and sell shares based on their view of the future prospects for the stock. But, the future prospects for the stock are influenced by unexpected news announcements. Prices could adjust to unexpected news in three basic ways: Efficient Market Reaction: The price instantaneously adjusts to the new information. Delayed Reaction: The price partially adjusts to the new information. Overreaction and Correction: The price over-adjusts to the new information, but eventually falls to the appropriate price. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson How New Information Gets into Stock Prices * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Event Studies Researchers have examined the effects of many types of news announcements on stock prices. Such researchers are interested in: The adjustment process itself The size of the stock price reaction to a news announcement. To test for the effects of new information on stock prices, researchers use an approach called an event study. Let us look at how researchers use this method. We will use a dramatic example. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Event Studies On Friday, May 25, 2007, executives of Advanced Medical Optics, Inc. (EYE), recalled a contact lens solution called Complete MoisturePlus Multi Purpose Solution. Advanced Medical Optics took this voluntary action after the Centers for Disease Control and Prevention (CDC) found a link between the solution and a rare cornea infection. The medical name for this cornea infection is acanthamoeba keratitis. The event study name for this cornea infection is AK. EYE Executives chose to recall their product even though no evidence was found that their manufacturing process introduced the parasite that can lead to AK. Further, company officials believed that the occurrences of AK were most likely the result of end users who failed to follow safe procedures when installing contact lenses. On Tuesday, May 29, 2007, EYE shares opened at $34.37, down $5.83 from the Friday closing price. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Event Studies * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Event Studies When researchers look for effects of news on stock prices, they must make sure that overall market news is accounted for in their analysis. To separate the overall market from the isolated news concerning Advanced Medical Optics, Inc., researchers would calculate abnormal returns: Abnormal return = Observed return – Expected return The expected return is calculated using a market index (like the Nasdaq 100 or the S&P 500 Index) or by using a long-term average return on the stock. Researchers then align the abnormal return on a stock to the days relative to the news announcement. Researchers usually assign the value of zero to the news announcement day. One day after the news announcement is assigned a value of +1. Two days after the news announcement is assigned a value of +2, and so on. Similarly, one day before the news announcement is assigned the value of -1. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Event Studies According to the EMH, the abnormal return today should only relate to information released on that day. To evaluate abnormal returns, researchers usually accumulate them over a 60 or 80-day period. The next slide is a plot of cumulative abnormal returns for Advanced Medical Optics, Inc. beginning 40 days before the announcement. The first cumulative abnormal return, or CAR, is just equal to the abnormal return on day -40. The CAR on day -39 is the sum of the first two abnormal returns. The CAR on day -38 is the sum of the first three, and so on. By examining CARs, researchers can see if there was over- or under-reaction to an announcement. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Event Studies * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Event Studies As you can see, Advanced Medical Optics, Inc.’s cumulative abnormal return hovered around zero before the announcement. After the news was released, there was a large, sharp downward movement in the CAR. The overall pattern of cumulative abnormal returns is essentially what the EMH would predict. That is: There is a band of cumulative abnormal returns, A sharp break in cumulative abnormal returns, and Another band of cumulative abnormal returns. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Informed Traders and Insider Trading If a market is strong-form efficient, no information of any kind, public or private, is useful in beating the market. But, it is clear that significant inside information would enable you to earn substantial excess returns. This fact generates an interesting question: Should any of us be able to earn returns based on information that is not known to the public? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Informed Traders and Insider Trading It is illegal to make profits on non-public information. It is argued that this ban is necessary if investors are to have trust in U.S. stock markets. The United States Securities and Exchange Commission (SEC) enforces laws concerning illegal trading activities. It is important to be able to distinguish between: Informed trading Legal insider trading Illegal insider trading * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Informed Trading When an investor makes a decision to buy or sell a stock based on publicly available information and analysis, this investor is said to be an informed trader. The information that an informed trader possesses might come from: Reading the Wall Street Journal Reading quarterly reports issued by a company Gathering financial information from the Internet Talking to other investors * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Legal Inside Trading Some informed traders are also insider traders. When you hear the term insider trading, you most likely think that such activity is illegal. But, not all insider trading is illegal. Company insiders can make perfectly legal trades in the stock of their company. They must comply with the reporting rules made by the SEC. When company insiders make a trade and report it to the SEC, these trades are reported to the public by the SEC. In addition, corporate insiders must declare that trades that they made were based on public information about the company, rather than “inside” information. * * * Who is an “Insider”? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson For the purposes of defining illegal insider trading, an insider is someone who has material non-public information. Such information is both not known to the public and, if it were known, would impact the stock price. A person can be charged with insider trading when he or she acts on such information in an attempt to make a profit. * * Illegal Insider Trading Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson When an illegal insider trade occurs, there is a tipper and a tippee. The tipper is the person who has purposely divulged material non-public information. The tippee is the person who has knowingly used such information in an attempt to profit. It is difficult for the SEC to prove that a trader is truly a tippee. It is difficult to keep track of insider information flows and subsequent trades. Suppose a person makes a trade based on the advice of a stockbroker. Even if the broker based this advice on material non-public information, the trader might not have been aware of the broker’s knowledge. The SEC must prove that the trader was, in fact, aware that the broker’s information was based on material non-public information. Sometimes, people accused of insider trading claim that they just “overheard” someone talking. Be aware: When you take possession of material non-public information, you become an insider and are bound to obey insider trading laws. * * It’s Not a Good Thing: What Did Martha Do? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The SEC believed that Ms. Stewart was told by her friend, Sam Waksal, who founded a company called ImClone, that a cancer drug being developed by ImClone had been rejected by the Food and Drug Administration. This development would be bad news for ImClone shares. Martha Stewart sold her 3,928 shares in ImClone on December 27, 2001. On that day, ImClone traded below $60 per share, a level that Ms. Stewart claimed triggered an existing stop-loss order. However, the SEC believed that Ms. Stewart illegally sold her shares because she had information concerning the FDA rejection before it became public. The FDA rejection was announced after the market closed on Friday, December 28, 2001. This news was a huge blow to ImClone shares, which closed at about $46 per share on the following Monday (the first trading day after the information became public). * * It’s Not a Good Thing: What Did Martha Do? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson In June 2003, Ms. Stewart and her stock broker, Peter Bacanovic, were indicted on nine federal counts. They both plead not guilty. Ms. Stewart’s trial began in January 2004. Just days before the jury began to deliberate, however, Judge Miriam Cedarbaum dismissed the most serious charge of securities fraud. Ms. Stewart, however, was convicted on all four counts of obstructing justice. Judge Cedarbaum fined Ms. Stewart $30,000 and sentenced her to five months in prison, two years of probation, and five months of home confinement. The fine was the maximum allowed under federal rules while the sentence was the minimum the judge could impose. Peter Bacanovic, Ms. Stewart's broker, was fined $4,000 and was sentenced to five months in prison and two years of probation. So, to summarize: Martha Stewart was accused, but not convicted, of insider trading. Martha Stewart was accused, and convicted, of obstructing justice. * * Are Financial Markets Efficient? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Financial markets are the most extensively documented of all human endeavors. Colossal amounts of financial market data are collected and reported every day. These data, particularly stock market data, have been exhaustively analyzed to test market efficiency. But, market efficiency is difficult to test for these four basic reasons: The risk-adjustment problem The relevant information problem The dumb luck problem The data snooping problem * * Are Financial Markets Efficient? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Nevertheless, three generalities about market efficiency can be made: Short-term stock price and market movements appear to be difficult to predict with any accuracy. The market reacts quickly and sharply to new information, and various studies find little or no evidence that such reactions can be profitably exploited. If the stock market can be beaten, the way to do so is not obvious. * * Some Implications if Markets are Efficient Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Security selection becomes less important, because securities will be fairly priced. There will be a small role for professional money managers. It makes little sense to time the market. * * Market Efficiency and the Performance of Professional Money Makers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Let’s have a stock market investment contest in which you are going to take on professional money managers. The professional money managers have at their disposal their skill, banks of computers, and scores of analysts to help pick their stocks. Does this sound like an unfair match? You have a terrific advantage if you follow this investment strategy: Hold a broad-based market index. One such index that you can easily buy is a mutual fund called the Vanguard 500 Index Fund (there are other market index mutual funds) The fund tracks the performance of the S&P 500 Index by investing its assets in the stocks that make up the S&P 500 Index. * * Market Efficiency and the Performance of Professional Money Managers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Market Efficiency and the Performance of Professional Money Managers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The previous slide shows the number of these funds that beat the performance of the Vanguard 500 Index Fund. You can see that there is much more variation in the dashed blue line than in the dashed red line. What this means is that in any given year, it is hard to predict how many professional money managers will beat the Vanguard 500 Index Fund. But, the low level and variation of the dashed red line means that the percentage of professional money managers who can beat the Vanguard 500 Index Fund over a 10-year investment period is low and stable. * * Market Efficiency and the Performance of Professional Money Managers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Market Efficiency and the Performance of Professional Money Managers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Market Efficiency and the Performance of Professional Money Managers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Two previous slides show the percentage of managed equity funds that beat the Vanguard 500 Index Fund. In only 12 of the 24 years (1986—2009) did more than half beat the Vanguard 500 Index Fund. The performance is worse when it comes to a 10-year investment periods (1977-1986 through 2000-2009). In only 5 of these 24 investment periods did more than half the professional money managers beat the Vanguard 500 Index Fund. * * Market Efficiency and the Performance of Professional Money Managers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The upcoming slide presents more evidence concerning the performance of professional money managers. Using data from 1980 through 2009, we divide this time period into: 1-year investment periods Rolling 3-year investment periods Rolling 5-year investment periods Rolling 10-year investment periods Then, after we calculate the number of investment periods, we ask two questions: What percent of the time did half the professionally managed funds beat the Vanguard 500 Index Fund? What percent of the time did three-fourths of them beat the Vanguard 500 Index Fund? * * Market Efficiency and the Performance of Professional Money Managers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Market Efficiency and the Performance of Professional Money Managers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The previous slides raise some potentially difficult and uncomfortable questions for security analysts and other investment professionals. If markets are inefficient, and tools like fundamental analysis are valuable, why can’t mutual fund managers beat a broad market index? The performance of professional money managers is especially troublesome when we consider the enormous resources at their disposal and the substantial survivorship bias that exists. Managers and funds that do especially poorly disappear. If it were possible to beat the market, then the process of elimination should lead to a situation in which the survivors can beat the market. The fact that professional money managers seem to lack the ability to outperform a broad market index is consistent with the notion that the equity market is efficient. * * What is the Role for Portfolio Managers in an Efficient Market? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The role of a portfolio manager in an efficient market is to build a portfolio to the specific needs of individual investors. A basic principle of investing is to hold a well-diversified portfolio. However, exactly which diversified portfolio is optimal varies by investor. Some factors that influence portfolio choice include the investor’s age, tax bracket, risk aversion, and even employer. Employer? Suppose you work for Starbucks and part of your compensation is stock options. Like many companies, Starbucks offers its employees the opportunity to purchase company stock at less than market value. You can imagine that you could wind up with a lot of Starbucks stock in your portfolio, which means you are not holding a diversified portfolio. The role of your portfolio manager would be to help you add other assets to your portfolio so that it is once again diversified. * * Anomalies Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson We will now present some aspects of stock price behavior that are both baffling and potentially hard to reconcile with market efficiency. Researchers call these market anomalies. Three facts to keep in mind about market anomalies. First, anomalies generally do not involve many dollars relative to the overall size of the stock market. Second, many anomalies are fleeting and tend to disappear when discovered. Finally, anomalies are not easily used as the basis for a trading strategy, because transaction costs render many of them unprofitable. * * The Day-of-the-Week Effect: Mondays Tend to Have a Negative Average Return Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The day-of-the-week effect refers to the tendency for Monday to have a negative average return—which is economically significant. Interestingly, the effect is much stronger in the 1950-1979 time period than in the 1980-2009 time period. * The Amazing January Effect The January effect refers to the tendency for small-cap stocks to have large returns in January. Does the January effect exist for the S&P 500? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The Amazing January Effect Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson But, what do we see when we look at returns on small-cap stocks? * The Turn-of-the-Year Effect Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Researchers have deeply explored the January effect to see whether: the effect is due to returns during the whole month of January, or due to returns bracketing the end of the year. Researchers look at returns over a specific three-week period and compare these returns to the returns for the rest of the year. As shown on the next slide, we have calculated daily market returns from 1962 through 2009. “Turn of the Year Days:” the last week of daily returns in a calendar year and the first two weeks of daily returns in the next calendar year. “Rest of the Days:” Any daily return that does not fall into this three-week period. * The Turn-of-the-Year Effect Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson As you can see, the “Turn of the Year” returns are higher than the “Rest of the Days” returns. The difference is biggest in the 1962-1985 period. * The Turn-of-the-Month Effect Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Researchers have also investigated whether a “Turn-of-the-Month” effect exists. On the next slide, we have separated daily stock market returns into two categories. “Turn of the Month Days:” Daily returns from the last day of any month or the following three days of the following month “Rest of the Days:” Any other daily returns * * The Turn-of-the-Month Effect Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson “Turn of the Month” returns exceed “Rest of the Days” returns. The turn-of-the-month effect is apparent in all three time periods. Interestingly, the effect appears to be as strong in the 1986-2009 period than in the 1962-1985 period. The fact that this effect exists puzzles EMH proponents. * Bubbles and Crashes Bubble: occurs when market prices soar far in excess of what normal and rational analysis would suggest. Investment bubbles eventually pop. When a bubble does pop, investors find themselves holding assets with plummeting values. A bubble can form over weeks, months, or even years. Crash: significant and sudden drop in market values. Crashes are generally associated with a bubble. Crashes are sudden, generally lasting less than a week. However, the financial aftermath of a crash can last for years. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The Crash of 1929 Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The Crash of 1929—The Aftermath Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The Crash of 1987 Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Once, when we spoke of the Crash, we meant October 29, 1929. That was until October 1987. The Crash of 1987 began on Friday, October 16th. The DJIA fell 108 points to close at 2,246.73. First time in history that the DJIA fell by more than 100 points in one day. On October 19, 1987, the DJIA lost about 22.6% of its value on a new record volume (about 600 million shares) The DJIA plummeted 508.32 points to close at 1,738.74. During the day on Tuesday, October 20th, the DJIA continued to plunge in value, reaching an intraday low of 1,616.21. But, the market rallied and closed at 1,841.01, up 102 points. * The Crash of 1987—The Aftermath Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * Circuit Breakers Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson As a result of the Crash of 1987, there have been some significant market changes. One of the most interesting changes was the introduction of the NYSE circuit breakers. Different circuit breakers are triggered if the DJIA drops by 10, 20, or 30 percent. A 10 percent drop will halt trading for at most one hour A 20 percent drop will halt trading for at most two hours A 30 percent drop will halt trading for the remainder of the day * The Asian Crash Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The crash of the Nikkei Index, which began in 1990, lengthened into a particularly long bear market. It is quite like the Crash of 1929 in that respect. The Asian Crash started with a booming bull market in the 1980s. Japan and emerging Asian economies seemed to be forming a powerful economic force. The “Asian economy” became an investor outlet for those wary of the U.S. market after the Crash of 1987. * The AsianCrash—Aftermath Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The “Dot-Com” Bubble and Crash Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson By the mid-1990s, the rise in Internet usage and its global growth potential fueled widespread excitement over the “new economy.” Investors seemed to care only about big ideas. Investor euphoria led to a surge in Internet IPOs, which were commonly referred to as “DotComs” because so many of their names ended in “.com.” The lack of solid business models doomed many DotComs. Many of them suffered huge losses. * The “Dot-Com” Bubble and Crash Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The Crash of October 2008 Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The Dow Jones Average, January 2008 through April 2010 Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * Tests of Market Efficiency Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Studies demonstrate that different types of anomalies (January effect, small-firm effect, weekend effect) exist in stock markets. We also know that low-price earnings stocks produce higher returns than high P/E ratio stocks. Similarly stocks with high book-to-market value ratios earn higher returns than those with low ratios. These anomalies and the October 19, 1987, crash are evidence against semistrong-form market efficiency of stock markets. However, when we examine whether these inconsistencies can be exploited to earn positive abnormal returns, we conclude that this information does not produce them. * Tests of Market Efficiency Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Most importantly in different countries mutual fund managers using all the publicly available information generally do not consistently outperform the market index portfolio. On the other hand many papers demonstrate that not only insiders, but also investors who mimic insiders’ actions with a lag consistently earn abnormal returns. According to the results of these tests, no stock market is strong-form efficient. Many traders believe that major developed stock exchanges are semistrong-form efficient, in the sense that investors cannot consistently earn abnormal returns using past and publicly available stock information. * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review Foundations and Forms of Market Efficiency Some Implications of Market Efficiency Does Old Information Help Predict Future Stock Prices? Random Walks and Stock Prices How Does New Information Get into Stock Prices? Event Studies Informed Traders and Inside Trading How Efficient are Markets? Are Financial Markets Efficient? Some Implications of Market Efficiency The Performance of Professional Money Managers * 2 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review Anomalies The Day-of-the-Week Effect The Amazing January Effect Turn-of-the-Year Effect Turn-of-the-Month Effect Bubbles and Crashes The Crash of 1929 The Crash of October 1987 The Asian Crash The “Dot-Com” Bubble and Crash The Crash of 2008 Tests of Market Efficiency * 3 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * Chapter 2 Diversification and Risky Asset Allocation Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * 36 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Learning Objectives To get the most out of this chapter, spread your study time across: 1. How to calculate expected returns and variances for a security. 2. How to calculate expected returns and variances for a portfolio. 3. The importance of portfolio diversification. 4. The efficient frontier and the importance of asset allocation. * * * * Diversification Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Intuitively, we all know that if you hold many investments Through time, some will increase in value Through time, some will decrease in value It is unlikely that their values will all change in the same way Diversification has a profound effect on portfolio return and portfolio risk. But, exactly how does diversification work? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Diversification and Asset Allocation Our goal in this chapter is to examine the role of diversification and asset allocation in investing. In the early 1950s, professor Harry Markowitz was the first to examine the role and impact of diversification. Based on his work, we will see how diversification works, and we can be sure that we have “efficiently diversified portfolios.” An efficiently diversified portfolio is one that has the highest expected return, given its risk. You must be aware that diversification concerns expected returns. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Expected Returns Expected return is the “weighted average” return on a risky asset, from today to some future date. The formula is: To calculate an expected return, you must first: Decide on the number of possible economic scenarios that might occur. Estimate how well the security will perform in each scenario, and Assign a probability, ps, to each scenario. (BTW, finance professors call these economic scenarios, “states.”) The upcoming slides show how the expected return formula is used when there are two states. Note that the “states” are equally likely to occur in this example. BUT! They do not have to be equally likely--they can have different probabilities of occurring. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Expected Return Suppose: There are two stocks: Starcents Jpod We are looking at a period of one year. Investors agree that the expected return: for Starcents is 25 percent for Jpod is 20 percent Why would anyone want to hold Jpod shares when Starcents is expected to have a higher return? * * * * Expected Return Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The answer depends on risk Starcents is expected to return 25 percent But the realized return on Starcents could be significantly higher or lower than 25 percent Similarly, the realized return on Jpod could be significantly higher or lower than 20 percent. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Calculating Expected Returns * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Expected Risk Premium Recall: Suppose risk free investments have an 8% return. If so, The expected risk premium on Jpod is 12% The expected risk premium on Starcents is 17% This expected risk premium is simply the difference between The expected return on the risky asset in question and The certain return on a risk-free investment * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Calculating the Variance of Expected Returns The variance of expected returns is calculated using this formula: This formula is not as difficult as it appears. This formula says: add up the squared deviations of each return from its expected return after it has been multiplied by the probability of observing a particular economic state (denoted by “s”). The standard deviation is simply the square root of the variance. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Calculating Expected Returns and Variances: Equal State Probabilities Note that the second spreadsheet is only for Starcents. What would you get for Jpod? * Sheet1 Calculating Expected Returns: Starcents: Jpod: (1) (2) (3) (4) (5) (6) Return if Return if State of Probability of State Product: State Product: Economy State of Economy Occurs (2) x (3) Occurs (2) x (5) Recession 0.50 -0.20 -0.10 0.30 0.15 Boom 0.50 0.70 0.35 0.10 0.05 Sum: 1.00 E(Ret): 0.25 E(Ret): 0.20 Calculating Variance of Expected Returns: Starcents: (1) (2) (3) (4) (5) (6) (7) Return if State of Probability of State Expected Difference: Squared: Product: Economy State of Economy Occurs Return: (3) - (4) (5) x (5) (2) x (6) Recession 0.50 -0.20 0.25 -0.45 0.2025 0.10125 Boom 0.50 0.70 0.25 0.45 0.2025 0.10125 Sum: 1.00 Sum = the Variance: 0.20250 Standard Deviation: 0.45 Jmart: (1) (2) (3) (4) (5) (6) (7) Return if State of Probability of State Expected Difference: Squared: Product: Economy State of Economy Occurs Return: (3) - (4) (5) x (5) (2) x (6) Recession 0.50 0.30 0.20 0.10 0.0100 0.00500 Boom 0.50 0.10 0.20 -0.10 0.0100 0.00500 Sum: 1.00 Sum is Variance: 0.01000 Standard Deviation: 0.10 * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Expected Returns and Variances, Starcents and Jpod * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Portfolios Portfolios are groups of assets, such as stocks and bonds, that are held by an investor. One convenient way to describe a portfolio is by listing the proportion of the total value of the portfolio that is invested into each asset. These proportions are called portfolio weights. Portfolio weights are sometimes expressed in percentages. However, in calculations, make sure you use proportions (i.e., decimals). * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Portfolios: Expected Returns The expected return on a portfolio is a linear combination, or weighted average, of the expected returns on the assets in that portfolio. The formula, for “n” assets, is: In the formula: E(RP) = expected portfolio return wi = portfolio weight for portfolio asset i E(Ri) = expected return for portfolio asset i * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Calculating Portfolio Expected Returns Note that the portfolio weight in Jpod = 1 – portfolio weight in Starcents. * Sheet1 Calculating Expected Portfolio Returns: (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Starcents Starcents Jpod Jpod Portfolio Return if Portfolio Contribution Return if Portfolio Contribution Return State of Prob. State Weight Product: State Weight Product: Sum: Product: Economy of State Occurs in Starcents: (3) x (4) Occurs in Jpod: (6) x (7) (5) + (8) (2) x (9) Recession 0.50 -0.20 0.50 -0.10 0.30 0.50 0.15 0.05 0.025 Boom 0.50 0.70 0.50 0.35 0.10 0.50 0.05 0.40 0.200 Sum: 1.00 Sum is Expected Portfolio Return: 0.225 Calculating Variance of Expected Portfolio Returns: (1) (2) (3) (4) (5) (6) (7) Return if State of Prob. State Expected Difference: Squared: Product: Economy of State Occurs: Return: (3) - (4) (5) x (5) (2) x (6) Recession 0.50 0.05 0.225 -0.18 0.0306 0.01531 Boom 0.50 0.40 0.225 0.18 0.030625 0.01531 Sum: 1.00 Sum is Variance: 0.03063 Standard Deviation: 0.175 * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Variance of Portfolio Expected Returns Note: Unlike returns, portfolio variance is generally not a simple weighted average of the variances of the assets in the portfolio. If there are “n” states, the formula is: In the formula, VAR(RP) = variance of portfolio expected return ps = probability of state of economy, s E(Rp,s) = expected portfolio return in state s E(Rp) = portfolio expected return Note that the formula is like the formula for the variance of the expected return of a single asset. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Calculating Variance of Portfolio Expected Returns It is possible to construct a portfolio of risky assets with zero portfolio variance! What? How? (Open this spreadsheet, scroll up, and set the weight in Starcents to 2/11ths.) What happens when you use .40 as the weight in Starcents? * Sheet1 Calculating Expected Portfolio Returns: (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Starcents Starcents Jpod Jpod Portfolio Return if Portfolio Contribution Return if Portfolio Contribution Return State of Prob. State Weight Product: State Weight Product: Sum: Product: Economy of State Occurs in Starcents: (3) x (4) Occurs in Jpod: (6) x (7) (5) + (8) (2) x (9) Recession 0.50 -0.20 0.18 -0.04 0.30 0.82 0.25 0.21 0.105 Boom 0.50 0.70 0.18 0.13 0.10 0.82 0.08 0.21 0.105 Sum: 1.00 Sum is Expected Portfolio Return: 0.209 Calculating Variance of Expected Portfolio Returns: (1) (2) (3) (4) (5) (6) (7) Return if State of Prob. State Expected Difference: Squared: Product: Economy of State Occurs: Return: (3) - (4) (5) x (5) (2) x (6) Recession 0.50 0.209 0.209 0.00 0.0000 0.00000 Boom 0.50 0.209 0.209 0.00 0 0.00000 Sum: 1.00 Sum is Variance: 0.00000 Standard Deviation: 0.000 * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Diversification and Risks * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Diversification and Risk * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Fallacy of Time Diversification Young people are often told that they should hold a large percent of their portfolio in stocks. The advice could be correct, but often the typical argument used to support this advice is incorrect. The Typical Argument: Even though stocks are more volatile, over time, the volatility “cancels out.” Sounds logical, but the typical argument is incorrect. This argument is the fallacy of time diversification fallacy How can such a plausible argument be incorrect? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Fallacy of Time Diversification How can such logical-sounding advice be bad? You might remember from your statistics class that we can add variances. This fact means that an annual variance grows each year by multiplying the annual variance by the number of years. Standard deviations cannot be added together: An annual standard deviation grows each year by the square root of the number of years. As we showed earlier in the chapter, a randomly selected portfolio of large-cap stocks has an annual standard deviation of about 20%. If we held this portfolio for 16 years, the standard deviation would be about 80 percent, which is 20 percent multiplied by the square root of 16. Bottom line: Volatility increases over time—volatility does not “cancel out” over time. Investing in equity has a greater chance of having an extremely large value AND increases the probability of ending with a really low value. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Very Definition of Risk—A Wider Range of Possible Outcomes from Holding Equity * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson So, Should Younger Investors Put a High Percent of Their Money into Equity? The answer is probably still yes, but for logically sound reasons that differ from the reasoning underlying the fallacy of time diversification. If you are young and your portfolio suffers a steep decline in a particular year, what could you do? You could make up for this loss by changing your work habits (e.g., your type of job, hours, second job). People approaching retirement have little future earning power, so a major loss in their portfolio will have a much greater impact on their wealth. Thus, the portfolios of young people should contain relatively more equity (i.e., risk). * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Why Diversification Works Correlation: The tendency of the returns on two assets to move together. Imperfect correlation is the key reason why diversification reduces portfolio risk as measured by the portfolio standard deviation. Positively correlated assets tend to move up and down together. Negatively correlated assets tend to move in opposite directions. Imperfect correlation, positive or negative, is why diversification reduces portfolio risk. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Why Diversification Works The correlation coefficient is denoted by Corr(RA, RB) or simply, A,B. The correlation coefficient measures correlation and ranges from -1 to 1: -1 (perfect negative correlation) 0 (uncorrelated) +1 (perfect positive correlation) * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Why Diversification Works * * * Why Diversification Works Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Why Diversification Works Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Calculating Portfolio Risk Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson For a portfolio of two assets, A and B, the variance of the return on the portfolio is: Where: xA = portfolio weight of asset A xB = portfolio weight of asset B such that xA + xB = 1. (Important: Recall Correlation Definition!) * * The Importance of Asset Allocation Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Suppose that as a very conservative, risk-averse investor, you decide to invest all of your money in a bond mutual fund. Very conservative, indeed? Uh, is this decision a wise one? * * Correlation and Diversification Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Correlation and Diversification Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The various combinations of risk and return available all fall on a smooth curve. This curve is called an investment opportunity set, because it shows the possible combinations of risk and return available from portfolios of these two assets. A portfolio that offers the highest return for its level of risk is said to be an efficient portfolio. The undesirable portfolios are said to be dominated or inefficient. * * More on Correlation and the Risk-Return Trade-Off Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Example: Correlation and the Risk-Return Trade-Off, Two Risky Assets Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Sheet1 Expected Standard Inputs Return Deviation Risky Asset 1 14.0% 20.0% Risky Asset 2 8.0% 15.0% Correlation 30.0% Percentage in Risky Standard Expected Asset 1 Deviation Return -60.0% 23.4% 4.4% -50.0% 21.7% 5.0% -40.0% 20.1% 5.6% -30.0% 18.6% 6.2% -20.0% 17.2% 6.8% -10.0% 16.0% 7.4% 0.0% 15.0% 8.0% 10.0% 14.2% 8.6% 20.0% 13.7% 9.2% 30.0% 13.6% 9.8% 42.9% 13.8% 10.6% 50.0% 14.2% 11.0% 60.0% 14.9% 11.6% 70.0% 15.9% 12.2% 80.0% 17.1% 12.8% 90.0% 18.5% 13.4% 100.0% 20.0% 14.0% 110.0% 21.6% 14.6% 120.0% 23.3% 15.2% 130.0% 25.0% 15.8% 140.0% 26.8% 16.4% Sheet1 Standard Deviation Expected Return Efficient Set--Two Asset Portfolio * * The Importance of Asset Allocation Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson We can illustrate the importance of asset allocation with 3 assets. How? Suppose we invest in three mutual funds: One that contains Foreign Stocks, F One that contains U.S. Stocks, S One that contains U.S. Bonds, B Figure 11.6 shows the results of calculating various expected returns and portfolio standard deviations with these three assets. Expected Return Standard Deviation Foreign Stocks, F 18% 35% U.S. Stocks, S 12 22 U.S. Bonds, B 8 14 * * Risk and Return with Multiple Assets Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * Risk and Return with Multiple Assets We used these formulas for portfolio return and variance: But, we made a simplifying assumption. We assumed that the assets are all uncorrelated. If so, the portfolio variance becomes: Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * The Markowitz Efficient Frontier The Markowitz Efficient frontier is the set of portfolios with the maximum return for a given risk AND the minimum risk given a return. For the plot, the upper left-hand boundary is the Markowitz efficient frontier. All the other possible combinations are inefficient. That is, investors would not hold these portfolios because they could get either more return for a given level of risk or less risk for a given level of return. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Investors face two problems with they form portfolios of multiple securities from different asset classes. These are as follows: an asset allocation problem & a security selection problem. The asset allocation problem involves a decision regarding what percentage should be allocated among different asset classes ( stocks, bonds, derivatives, foreign securities). The security selection problem involves deciding which to pick in each class and what percentage to allocate to these securities (RIM, Royal Bank, Molson). * Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Professional Investors have traditionally used modern portfolio theory to help make investment decisions. This approach examines past returns, volatility and correlation to determine the optimum percentage of a portfolio to invest in to achieve an expected rate of return for a given level of risk. “Modern Portfolio theory focuses on diversifying your risk away, but the crisis has shown the limits of the approach.” What are the alternatives? How should investors be looking to construct their portfolios? * Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Investors should make asset allocations that give the best chance of meeting their own unique future financial commitments, rather then simply trying to maximize risk-adjusted returns. Life cycle investing, takes into account the investor’s specific time horizons, something that modern portfolio theory does not take into account. Controlling the overall risk level of investments to make sure it is in line with risk appetite. * Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson * * Useful Internet Sites Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson www.investopedia.com (for more on risk measures) www.teachmefinance.com (also contains more on risk measure) www.morningstar.com (measure diversification using “instant x-ray”) www.moneychimp.com (review modern portfolio theory) www.efficientfrontier.com (check out the reading list) * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review Expected Returns and Variances Expected returns Calculating the variance Portfolios Portfolio weights Portfolio expected returns Portfolio variance * 61 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review Diversification and Portfolio Risk The principle of diversification The fallacy of time diversification Correlation and Diversification Why diversification works Calculating portfolio risk More on correlation and the risk-return trade-off The Markowitz Efficient Frontier Risk and return with multiple assets * 62 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of [ ] å = ´ = n 1 s s i, s i return p return expected Rate Riskfree Return Expected Premium Risk Expected - = ( ) [ ] å = - ´ = = n 1 s 2 s s 2 return expected return p σ Variance Variance σ Deviation Standard = = (1)(3)(4)(5)(6) Return ifReturn if State ofStateProduct:StateProduct: EconomyOccurs(2) x (3)Occurs(2) x (5) Recession-0.20-0.100.300.15 Boom0.700.350.100.05 Sum:E(Ret):0.25E(Ret):0.20 (1)(3)(4)(5)(6)(7) Return if State ofStateExpectedDifference:Squared:Product: EconomyOccursReturn:(3) - (4)(5) x (5)(2) x (6) Recession-0.200.25-0.450.20250.10125 Boom0.700.250.450.20250.10125 Sum:0.20250 0.45 Calculating Expected Returns: Starcents:Jpod: (2) 1.00 Calculating Variance of Expected Returns: Starcents: (2) Probability of State of Economy 0.50 0.50 1.00Sum = the Variance: Standard Deviation: Probability of State of Economy 0.50 0.50 ( ) ( ) [ ] å = ´ = n 1 i i i P R E w R E (1)(2)(3)(4)(5)(6)(7)(8)(9)(10) StarcentsStarcentsJpodJpodPortfolio Return ifPortfolioContributionReturn ifPortfolioContributionReturn State ofProb.StateWeightProduct:StateWeightProduct:Sum:Product: Economyof State Occursin Starcents:(3) x (4)Occursin Jpod:(6) x (7)(5) + (8)(2) x (9) Recession0.50-0.200.50-0.100.300.500.150.050.025 Boom0.500.700.500.350.100.500.050.400.200 Sum:1.000.225 Calculating Expected Portfolio Returns: Sum is Expected Portfolio Return: ( ) ( ) ( ) { } [ ] å = - ´ = n 1 s 2 P s p, s P R E R E p R VAR (1)(2)(3)(4)(5)(6)(7) Return if State ofProb.StateExpectedDifference:Squared:Product: Economyof State Occurs:Return:(3) - (4)(5) x (5)(2) x (6) Recession0.500.2090.2090.000.00000.00000 Boom0.500.2090.2090.0000.00000 Sum:1.00Sum is Variance:0.00000 0.000Standard Deviation: Calculating Variance of Expected Portfolio Returns: ) R CORR(R σ σ x 2x σ x σ x σ B) COV(A, x 2x σ x σ x σ B A B A B A 2 B 2 B 2 A 2 A 2 p B A 2 B 2 B 2 A 2 A 2 p + + = + + = ExpectedStandard InputsReturnDeviation Risky Asset 114.0%20.0% Risky Asset 28.0%15.0% Correlation30.0% Efficient Set--Two Asset Portfolio 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 0%5%10%15%20%25%30% Standard Deviation Expected Return 2 B 2 B 2 S 2 S 2 F 2 F 2 p B S B S B S B F B F B F S F S F S F 2 B 2 B 2 S 2 S 2 F 2 F 2 p B B S S F F p σ x σ x σ x σ ) R CORR(R σ σ x 2x ) R CORR(R σ σ x 2x ) R CORR(R σ σ x 2x σ x σ x σ x σ R x R x R x r + + = + + + + + = + + = * Chapter 3 The Investment Process Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * 42 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * The Investment Process Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson “Don’t Gamble! Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it.” – Will Rogers * * * Don’t sell yourself short. Instead, learn about these key investment subjects: 1. The importance of an investment policy statement. 2. The various types of securities brokers and brokerage accounts. 3. How to calculate initial and maintenance margin. 4. The workings of short sales. Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Learning Objectives * * * * Investing Overview Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Fundamental Question: Why invest at all? We invest today to have more tomorrow. Investment is simply deferred consumption. We choose to wait because we want more to spend later. Investors have their own investment objectives and strategies The Investment Policy Statement (IPS) Designed to reflect your objectives and strategies Two parts Objectives Constraints * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Objectives: Risk and Return In formulating investment objectives, the individual must balance return objectives with risk tolerance. Investors must think about risk and return. Investors must think about how much risk they can handle. Your risk tolerance is affected by Your ability to take risk Your willingness to take risk * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Investor Constraints Resources. What is the minimum sum needed? What are the associated costs? Trading commissions? Subsequent transactions? Horizon. When do you need the money? Buying a home? Retirement? Liquidity. How high is the possibility that you need to sell the asset quickly? Are funds for emergency purposes or long term goals? Taxes. Which tax bracket are you in? After tax returns are essential Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Investment Strategies and Policies Investment management. Should you manage your investments yourself? Investment Advisor or Broker? Financial Planner? Market timing. Should you try to buy and sell in anticipation of the future direction of the market? Asset allocation. How should you distribute your investment funds across the different classes of assets? Dependent on your risk tolerance Security selection. Within each class, which specific securities should you buy? Which stock and bonds to invest funds in & what percentage of funds to invest in each security? * * * * Asset Allocation or Security Selection? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Is asset allocation or security selection more important to the success of a portfolio? Most people are inclined to think security selection is the more important element for successful investing. Research shows, however, that asset allocation is the more important determinant of portfolio returns. Many experts suggest: About 90 percent of portfolio performance stems from asset allocation. So, 10 percent of portfolio performance comes from security selection. How is this result possible? Well, consider the Crash of 2008. Bonds outperformed stocks in 2008 Even those elusive “skilled stock pickers” might underperform bonds Stocks tend to move together Even a “skilled stock picker” would have trouble beating bonds if most stock prices are performing poorly relative to bond prices * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Choosing a Broker/Advisor What do you do after carefully crafting your Investment Policy Statement (IPS)? If so, you need to choose the type of brokerage account and your broker/advisor from: full-service brokers discount brokers deep-discount brokers These three groups can be distinguished by the level of service provided, as well as the level of commissions charged. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Choosing a Broker/Advisor As the brokerage industry becomes more competitive, the differences among broker types continues to blur. Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers. Online investing has really changed the brokerage industry. slashing brokerage commissions providing investment information Customers place buy and sell orders over the Internet Many full-service brokers offer an advisory-based relationship for clients. Rather than charging commissions on every transaction, the investment advisor charges an annual fee, say 1-2%, based on the account balance. This fee covers all services associated with advice and trading. An advisory-based relationship can align the interests of the client and the advisor. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Advisor-Customer Relations There are several important things to remember when you deal with any broker/advisor: Any advice you receive is not guaranteed. Your broker works as your agent and has a legal duty to act in your best interest. Brokerage firms, however, do make profits from brokerage commissions and/or annual fees. Your account agreement will probably specify that any disputes will be settled by arbitration and that the arbitration is final and binding. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Canadian Investor Protection Fund Canadian Investor Protection Fund (CIPF): Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties. Most brokerage firms belong to the CIPF, which insures each account for up to $1,000,000 in cash and securities Important: The CIPF does not guarantee the value of any security Rather, CIPF protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Opening Your Brokerage Account (c) Buy 100 Shares of Disney at $33 per share (e) $6,650 Cash in Account $3,300 Stock In Account (d) Pay Commission, Say $50 (b) Deposit $10,000 into account (a) Open a brokerage or trading account * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Two Types of Brokerage Accounts A Cash account is a brokerage account in which securities are paid for in full. A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit. (more on selling short later) * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Margin Accounts In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin. Of course, the portion that is borrowed incurs an interest charge. This interest is based on the broker’s call money rate. The call money rate is the rate brokers pay to borrow money to lend to customers in their margin accounts. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Margin Accounts, The Balance Sheet You buy 1,000 Pfizer (PFE) shares at $24 per share. You put up $18,000 and borrow the rest. Amount borrowed = $24,000 – $18,000 = $6,000 Margin = $18,000 / $24,000 = 75% Assets Liabilities and Account Equity 1,000 Shares, PFE $ 24,000 Margin Loan $ 6,000 Account Equity $ 18,000 Total $ 24,000 Total $ 24,000 * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Margin Accounts In a margin purchase, the minimum margin that must be supplied is called the initial margin. The maintenance margin is the margin amount that must be present at all times in a margin account. When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Workings of a Margin Account Your margin account requires: an initial margin of 50%, and a maintenance margin of 30% A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50. You have $20,000, and you want to buy as much WHOA as you can. You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA. Assets Liabilities and Account Equity 800 Shares of WHOA @ $50/share $ 40,000 Margin Loan $ 20,000 Account Equity $ 20,000 Total $ 40,000 Total $ 40,000 * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Workings of a Margin Account After your purchase, shares of WHOA fall to $35. (Woe!) New margin = $8,000 / $28,000 = 28.6% < 30% Therefore, you are subject to a margin call. Assets Liabilities and Account Equity 800 Shares of WHOA @ $35/share $ 28,000 Margin Loan $ 20,000 Account Equity $ 8,000 Total $ 28,000 Total $ 28,000 * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Effects of Margin You have $30,000 in a margin account, 60% initial margin required. You can buy $50,000 of stock with this account (why?). Your borrowing rate from your broker is 6.00%. Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share. Assume no dividends, and that your borrowing rate is still 6.00%, what is your return if: In one year, KO is selling for $60 per share? In one year, KO stock is selling for $60 per share, but you did not borrow money from your broker? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Effects of Margin KO is selling for $60 per share. Your investment is worth $60,000. You owe 6% on the $20,000 you borrowed: $1,200. If you pay off the loan with interest, your account balance is: $60,000 – $21,200 = $38,800. You started with $30,000. Therefore, your return is $8,800 / $30,000 = 29.33%. Suppose Coca-Cola stock was selling for $40 per share instead of $60 per share? What is your return? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Effects of Margin Coca-Cola stock is selling for $60 per share, but you did not borrow from your broker. You started with $30,000, which means you were able to buy $30,000 / $50 = 600 shares. Your investment is now worth $36,000. Therefore, your return is $6,000 / $30,000 = 20.00%. Suppose Coca-Cola is selling for $40 per share instead of $60 per share. What is your return in this case? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: How Low Can it Go? Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55 per share. Total cost: $16,500 You have only $9,900—so you must borrow $6,600. Your initial margin is $9,900/$16,500 = 60%. Suppose your maintenance margin is 40%. At what price will you receive a margin call? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: How Low Can it Go? (Answer) This will happen when the price of Pepsico, Inc. drops to $36.67. How so? Well, * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Annualizing Returns on a Margin Purchase You buy 1,000 shares of Costco (COST) at $60 per share. Your initial margin is 50%. You borrow at the 9 percent call money rate plus 2 percent. You sell Costco (COST) 4 months later for $63. There were no dividends paid (and suppose the prices above are net of commissions). What is your holding period percentage return and your EAR? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Annualizing Returns on a Margin Purchase Answer: First, you have to repay the 3-month loan, so t = (3/12 = .25) Amount Repaid = Amount Borrowed × (1 + interest rate per year)t Amount Repaid = $30,000 × (1 + .11).25 = $30,000 × 1.02643 = $30,792.90 Your Sale Proceeds = Cash from Sale – Amount Repaid = $63,000 – 30,792.90 = $32,207.10 Your Profit = Your Sale Proceeds – Your Investment = $32,207.10 - $30,000 = $2,207.10 * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Annualizing Returns on a Margin Purchase Note that there are 12/3 = 4 three-month holding periods in a year. Therefore, m = 4. * * * Hypothecation and Street Name Recognition Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Hypothecation is the act of pledging securities as a collateral against a loan. This pledge is needed so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call. Street name registration is an arrangement under which a broker is the registered owner of a security. (You, as the account holder are the “beneficial owner.”) * * Other Account Issues Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Trading accounts can also be differentiated by the ways they are managed. Advisory account - You pay someone else to make buy and sell decisions on your behalf. Wrap account - All the expenses associated with your account are “wrapped” into a single fee. Discretionary account - You authorize your broker to trade for you. Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans. * * Other Account Issues Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson To invest in financial securities, you do not need an account with a broker. One alternative is to buy securities directly from the issuer. Another alternative is to invest in mutual funds. * * Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Short Sale is a sale in which the seller does not actually own the security that is sold. Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position.” Borrow shares from someone Sell the Shares in the market Buy shares From the market Return the shares Today In the Future * * Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson An investor with a long position benefits from price increases. Easy to understand You buy today at $34, and sell later at $57, you profit! Buy low, sell high An investor with a short position benefits from price decreases. Also easy to understand You sell today at $83, and buy later at $27, you profit. Sell high, buy low * * Example: Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson You short 100 shares of Verizon Communications (VZ) at $30 per share. Your broker has a 50% initial margin and a 40% maintenance margin on short sales. The value of stock borrowed that will be sold short is: $30 × $100 = $3,000 Assets Liabilities and Account Equity Sale Proceeds $ 3,000 Short Position $ 3,000 Initial Margin Deposit $ 1,500 Account Equity $ 1,500 Total $ 4,500 Total $ 4,500 * * Example: Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Verizon Communications stock price falls to $20 per share. Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000. Also, new margin: $2,500 / $2,000 = 125% Assets Liabilities and Account Equity Sale Proceeds $ 3,000 Short Position $ 2,000 Initial Margin Deposit $ 1,500 Account Equity $ 2,500 Total $ 4,500 Total $ 4,500 * * Example: Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Verizon Communications stock price rises to $40 per share. You sold short at $30, stock price is now $40, you are "behind" by $10 per share, or $1,000. (“He who sells what isn’t his’n, must buy it back—or go to prison.”) Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call. Assets Liabilities and Account Equity Sale Proceeds $ 3,000 Short Position $ 4,000 Initial Margin Deposit $ 1,500 Account Equity $ 500 Total $ 4,500 Total $ 4,500 * * More on Short Sales Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Short interest is the amount of common stock held in short positions. In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers. Note that with a short position, you may lose more than your total investment, as there is no theoretical limit to how high the stock price may rise. Short Sellers face Constraints. From government intervention Also, there might not be enough shares available to borrow to short sell. Constraints reduce liquidity, increase volatility, and lead to inefficient pricing. * * Finding Actual Short Positions (from finance.yahoo.com) Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Forming a Real Investment Portfolio Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Take the Risk Tolerance Quiz in the textbook. What score did you get? * Forming a Real Investment Portfolio What does your score mean? Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * * Useful Internet Sites Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson www.finra.org (a reference for dispute resolution) www.bearmarketcentral.com (a reference for short selling) www.nasdaq.com (a reference for short interest) www.moneycentral.msn.com (a reference for building a portfolio—search the site for “Build your first stock portfolio”) www.sharebuilder.com (a reference for opening a brokerage account) www.buyandhold.com (another reference for opening a brokerage account) www.individual.ml.com (a risk tolerance questionnaire from Merrill Lynch) www.money-rates.com (a reference for current broker call money rate) finance.yahoo.com (a reference for short sales on particular stocks) * * * The importance of an investment policy statement (IPS). The investment policy statement (IPS) identifies the objectives (risk and return) of an investor, as well as the constraints the investor faces in achieving these objectives. The IPS provides an investing “roadmap” and will influence the strategies, type of account, and holdings an investor chooses. The various types of securities brokers Choosing a Broker Online Brokers Security Investors Protection Corporation Broker-Customer Relations Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review * 81 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * * Brokerage Accounts Cash Accounts Margin Accounts and how to calculate initial and maintenance margin A Note on Annualizing Returns Short Sales Basics of a Short Sale Some Details Forming a Real Investment Portfolio Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Chapter Review * 82 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of ( ) $36.67. 0.60 22 0.40 - 1 300 $6,600 P here, So Level Margin e Maintenanc - 1 Shares of Number Borrowed Amount P in results , P price, stock critical the for Solving P Shares of Number Borrowed Amount P Shares of Number Level Margin e Maintenanc * * * * * = = = = ´ - ´ = 32.85%. about is EAR your So 1.3285 0.0736) (1 Return) Percentage Period Holding (1 EAR 1 0.0736 $30,000 $2,207.10 $30,000 $30,000 - $32,207.10 Return Percentage Period Holding 4 m = + = + = + = = = * Chapter 7 Brief History of Risk and Return Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson * 1 VALUATION AND MANAGEMENT Investments JORDAN MILLER DOLVIN YÜCE third canadian edition fundamentals of * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Learning Objectives Separate yourself from the commoners by having a good understanding of these security valuation methods: 1. The basic dividend discount model. 2. The two-stage dividend growth model. 3. The residual income model and free cash flow model. 4. Price ratio analysis. * * * * Common Stock Valuation Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Our goal in this chapter is to examine the methods commonly used by financial analysts to assess the economic value of common stocks. These methods are grouped into four categories: Dividend discount models Residual Income model Free Cash Flow model Price ratio models * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Security Analysis: Be Careful Out There Fundamental analysis is a term for studying a company’s accounting statements and other financial and economic information to estimate the economic value of a company’s stock. The basic idea is to identify “undervalued” stocks to buy and “overvalued” stocks to sell. In practice however, such stocks may in fact be correctly priced for reasons not immediately apparent to the analyst. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Dividend Discount Model The Dividend Discount Model (DDM) is a method to estimate the value of a share of stock by discounting all expected future dividend payments. The basic DDM equation is: In the DDM equation: P0 = the present value of all future dividends Dt = the dividend to be paid t years from now k = the appropriate risk-adjusted discount rate * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Dividend Discount Model Suppose that a stock will pay three annual dividends of $200 per year, and the appropriate risk-adjusted discount rate, k, is 8%. In this case, what is the value of the stock today? * * * * The Dividend Discount Model: The Constant Growth Rate Model Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Assume that the dividends will grow at a constant growth rate g. The dividend in the next period, (t + 1), is: For constant dividend growth for “T” years, the DDM formula becomes: * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: The Constant Growth Rate Model Suppose the current dividend is $10, the dividend growth rate is 10%, there will be 20 yearly dividends, and the appropriate discount rate is 8%. What is the value of the stock, based on the constant growth rate model? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Dividend Discount Model: The Constant Perpetual Growth Model Assuming that the dividends will grow forever at a constant growth rate g. For constant perpetual dividend growth, the DDM formula becomes: * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Constant Perpetual Growth Model Think about the electric utility industry. In 2009, the dividend paid by the utility company, DTE Energy Co. (DTE), was $2.12. Using D0 =$2.12, k = 5.75%, and g = 2%, calculate an estimated value for DTE. Note: the actual mid-2009 stock price of DTE was $40.29. What are the possible explanations for the difference? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Dividend Discount Model: Estimating the Growth Rate The growth rate in dividends (g) can be estimated in a number of ways: Using the company’s historical average growth rate. Using an industry median or average growth rate. Using the sustainable growth rate. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Historical Average Growth Rate Suppose the Broadway Joe Company paid the following dividends: 2005: $1.50 2008: $1.80 2006: $1.70 2009: $2.00 2007: $1.75 2010: $2.20 The spreadsheet below shows how to estimate historical average growth rates, using arithmetic and geometric averages. * Sheet1 Year: Dividend: Pct. Chg: 2010 $2.20 10.00% 2009 $2.00 11.11% 2008 $1.80 2.86% Grown at 2007 $1.75 2.94% Year: 7.96%: 2006 $1.70 13.33% 2005 $1.50 2005 $1.50 2006 $1.62 2007 $1.75 Arithmetic Average: 8.05% 2008 $1.89 2009 $2.04 Geometric Average: 7.96% 2010 $2.20 * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Sustainable Growth Rate Return on Equity (ROE) = Net Income / Equity Payout Ratio = Proportion of earnings paid out as dividends Retention Ratio = Proportion of earnings retained for investment * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Calculating and Using the Sustainable Growth Rate In 2009, American Electric Power (AEP) had an ROE of 10%, projected earnings per share of $2.90, and a per-share dividend of $1.64. What was AEP’s: Retention rate? Sustainable growth rate? Payout ratio = $1.64 / $2.90 = .566 or 56.6% So, retention ratio = 1 – .566 = .434 or 43.4% Therefore, AEP’s sustainable growth rate = .10  .434 = .0434, or 4.34% * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Calculating and Using the Sustainable Growth Rate What is the value of AEP stock using the perpetual growth model and a discount rate of 5.75%? The actual late-2009 stock price of AEP was $31.83. In this case, using the sustainable growth rate to value the stock gives a reasonably poor estimate. What can we say about g and k in this example? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Analyzing ROE To estimate a sustainable growth rate, you need the (relatively stable) dividend payout ratio and ROE. Changes in sustainable growth rate likely stem from changes in ROE. The DuPont formula separates ROE into three parts (profit margin, asset turnover, equity multiplier) Managers can increase the sustainable growth rate by: Decreasing the dividend payout ratio Increasing profitability (Net Income / Sales) Increasing asset efficiency (Sales / Assets) Increasing debt (Assets / Equity) * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The Two-Stage Dividend Growth Model The two-stage dividend growth model assumes that a firm will initially grow at a rate g1 for T years, and thereafter, it will grow at a rate g2 < k during a perpetual second stage of growth. The Two-Stage Dividend Growth Model formula is: * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Using the Two-Stage Dividend Growth Model Although the formula looks complicated, think of it as two parts: Part 1 is the present value of the first T dividends (it is the same formula we used for the constant growth model). Part 2 is the present value of all subsequent dividends. So, suppose MissMolly.com has a current dividend of D0 = $5, which is expected to shrink at the rate, g1 = 10%, for 5 years but grow at the rate, g2 = 4%, forever. With a discount rate of k = 10%, what is the present value of the stock? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Using the Two-Stage Dividend Growth Model The total value of $46.03 is the sum of a $14.25 present value of the first five dividends, plus a $31.78 present value of all subsequent dividends. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth Chain Reaction, Inc., has been growing at a phenomenal rate of 30% per year. You believe that this rate will last for only three more years. Then, you think the rate will drop to 10% per year. Total dividends just paid were $5 million. The required rate of return is 20%. What is the total value of Chain Reaction, Inc.? * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth First, calculate the total dividends over the “supernormal” growth period: Using the long run growth rate, g, the value of all the shares at Time 3 can be calculated as: P3 = [D3 x (1 + g)] / (k – g) P3 = [$10.985 x 1.10] / (0.20 – 0.10) = $120.835 Year Total Dividend: (in $millions) 1 $5.00 x 1.30 = $6.50 2 $6.50 x 1.30 = $8.45 3 $8.45 x 1.30 = $10.985 * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Example: Using the DDM to Value a Firm Experiencing “Supernormal” Growth To determine the present value of the firm today, we need the present value of $120.835 and the present value of the dividends paid in the first 3 years: If there are 20 million shares outstanding, the price per share is $4.38. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The H-Model For Chain Reaction, Inc., we assumed a supernormal growth rate of 30 percent per year for three years, and then growth at a perpetual 10 percent. The growth rate is more likely to start at a high level and then fall over time until reaching its perpetual level. Many possible ways to assume how the growth rate declines A popular way is the H-model: which assumes a linear growth rate decline * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson The H-Model Let’s revisit Chain Reaction, Inc. Suppose the growth rate begins at 30% and reaches 10% in year 4 and beyond. Using the H-model, we would assume that the company’s growth rate would decline by 20% from the end of year 1 to the beginning of year 4. If we assume a linear decline: the growth rate falls by 6.67% per year (20%/3 years). Growth estimates would be: 30%, 23.33%, 16.66%, and 10% Using these growth estimates, you will find that the firm value is $75.93 million, or $3.80 per share. The value is lower than before because of the lower growth rates in years 2 and 3. * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Discount Rates for Dividend Discount Models The discount rate for a stock can be estimated using the capital asset pricing model (CAPM ). We will discuss the CAPM in a later chapter. However, we can estimate the discount rate for a stock using this formula: Discount rate = time value of money + risk premium = U.S. T-bill Rate + (Stock Beta x Stock Market Risk Premium) T-bill Rate: return on 90-day U.S. T-bills Stock Beta: risk relative to an average stock Stock Market Risk Premium: risk premium for an average stock * * * * Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson Observations on Dividend Discount Model Constant Perpetual Growth Model: Simple to compute Not usable for firms that do not pay dividends Not usable when g > k
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.
Constant perpetual growth is often an unrealistic assumption.

Duckwall—Alco Stores, Inc. (DUCK)
It is July 1, 2010—shares are selling in the market for $10.94.
Using the RIM:
EPS0 = $1.20
DIV = 0
B0 = $5.886
g = 0.09
k = .13

What can we say
about the market
price of DUCK?

Using the information from the previous slide, what growth rate results in a DUCK price of $10.94?

What happens when a firm has no debt?
tax rate.

Late-2009 stock price = $19.40

*
The McGraw-Hill Company Analysis, III

Based on the CAPM, k = 4.0% + (1.2  7%) = 12.4%
Retention ratio = 1 – $.90/$2.55 = .65
Sustainable g = .65  36.5% = 23.73%

*
The McGraw-Hill Company Analysis
(Using the Residual Income Model)

Using the CSR assumption:

www.nyssa.org (The New York Society of Security Analysts)

www.aaii.com (The American Association of Individual Investors)

www.valueline.com (the home of the Value Line Investment Survey)
Websites for some companies analyzed in this chapter:

www.aep.com

www.intel.com

www.mcgraw-hill.com

Security Analysis: Be Careful Out There

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

Residual Income Model (RIM)
Free Cash Flow Model

Price Ratio Analysis
Price-Earnings Ratios
Price-Cash Flow Ratios
Price-Sales Ratios
Price-Book Ratios
Applications of Price Ratio Analysis
An Analysis of the McGraw-Hill Company

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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