Transcript Capital Asset Pricing Model - Metropolitan DC Chapter AAII

Investment Workshop Topics
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Constructing a Portfolio (Stocks, bonds, Funds, Real
Estate, Tangibles)
Risk and Return – is there a trade-off?
Efficient Market Theory and Modern Portfolio Theory
(MPT)
Components of MPT
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Correlation
Portfolio Standard Deviation
The Efficient Frontier
Risk-adjusted Return Measures
Topics
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Traditional Portfolio Management
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Dividends
Technical Analysis
Information from financial statements
Fundamental Analysis
Portfolio Construction and Management
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Record goals, tax situation, financial resources, liquidity
requirements, risk tolerance and investment attitude.
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Look at the world and national political, economic and investing
climates.
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Determine a strategy to develop the portfolio.
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Screen potential investments to meet the needs and suit the risk
tolerance.
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Select investments based upon sound company fundamentals,
the management team and the overall business climate.
Portfolio Construction and Management
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Evaluate the portfolio. Reposition assets as
necessary.
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Determine $$ needed to meet each goal. How much
must be invested and what must the return be?
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Place $$ to fund the highest priority goals.
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Monitor performance, situational changes (will you be
having kids, retiring, paying for a wedding, going on
vacation, etc.) changes in the economy. Revise the
portfolio accordingly.
Risk and Return
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Risk: The uncertainty of return vs expected.
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Return: What you get for your invested money
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Appreciation of asset value
Interest
Dividends
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Rent received
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Types of Risk
Systematic Risk
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Stems from events such as war, inflation, recession
and high interest rates. These events have an
impact on all business simultaneously. Therefore,
you cannot reduce this risk through diversification.
Market Risk – A type of systematic risk where
investor psychology changes. Corporate earnings
may be declining, so even though all company
earnings are not bad, they all go down.
Systematic Risk
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Interest Rate Risk - Variation of interest rates.
Reinvestment Rate Risk – Interest rates decline. When
bonds mature, the money has to be reinvested at the lower
rates.
Purchasing Power Risk – Rising inflation reduces future
purchasing power.
Exchange Rate Risk – If the dollar increases in value vs
another currency, investments denominated in that currency will
decrease in value.
Types of Risk
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Unsystematic Risk -- This is diversifiable risk. It arises from
factors unique to a particular business.
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Business Risk – How a firm makes money, its competition,
potential for strikes, etc.
Financial Risk – Debt vs equity financing. Debt increases the
fixed costs of a firm. If sales decline, fixed costs stay, profits
decline.
Default Risk – Issuer of bonds may not pay the obligation
Defining Risk
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Variability of Returns
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Measure total Risk by Standard Deviation
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Represented by the Greek Letter Sigma ()
 is really the dispersion of returns around the
mean or expected mean. Outcomes tend to
cluster around the mean; a bell curve can be used
to represent outcomes. This "normal" curve is
useful in determining probabilities of outcomes.
Beta ()
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Measure Systematic risk by Beta (). It
assumes that unsystematic risk has been
diversified away. How?
Indicates how the price of a security responds
to market forces. Plot historical returns of
the security vs. historical returns of the
market. The slope of the line is .
Beta for the market is 1.0 (whichever market
you use as a reference).
Beta ()
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The greater the , the more volatile the stock or
fund.
With a higher , the expected return should be
higher (Risk vs Return).
Coefficient of Determination
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R2 is called the Coefficient of
Determination. It tells you how good
your Beta is, or whether you should use
Beta at all. When viewed against the
market, it tells how much of the
portfolio risk is systematic.
Required Return
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What you think the investment will earn in the future,
in terms of income and capital gains. The more
uncertain the investment is (more risk), the higher
the required return should become. This added
expectation is the risk premium.
You could go into an investment deciding what your
minimum requirement is or you can do it by formula.
Capital Asset Pricing Model (CAPM)
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Developed by Sharpe and Lintner. It is an equation
relating the required investment return to the risk
free rate, the market premium and .
Ri = Rf + (RM -Rf) 
Where RM is the market return, Rf is the risk free rate
and Ri is the required return. The return we calculate
is the discount factor we should apply to future
earnings to determine value.
Efficient Market theory
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Markets are so efficient that stock prices are properly
valued and thus investors cannot consistently
outperform the market.
Reasons:
 There are a large number of profit maximizing
participants concerned with analysis and valuation of
securities operating independently of each other.
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New information is widely available and random.
Efficient Market theory
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Stock prices adjust rapidly in response to the new
information
Therefore stock prices represent past and current
news, as well as future projections.
Weak Form
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Past prices are of no use in predicting future price
changes (i.e., technical analysis is no good). Prices
follow a “random walk.”
Efficient Market theory
Semi-strong Form
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Asserts that large, abnormally high profits cannot be
earned consistently using publicly available
information, because stock prices adjust so quickly to
new information (therefore, technical and
fundamental analysis is no good).
Efficient Market theory
Strong Form
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There is no information, public or private that allows
investors to consistently earn abnormally high profits.
Thus, even insider info is of no long-term benefit.
Modern Portfolio Theory (MPT)
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Portfolio construction is based on statistical
measures, such as expected returns, standard
deviation and correlation.
Diversification is reached by combining assets
that have returns of negative or low
correlation between them.
Practically we look at Beta and R2,
theoretically we can also look at the efficient
frontier.
Modern Portfolio Theory (MPT)
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If assets are perfectly correlated, their combination
cannot produce a standard deviation below that of
the least risky asset. The maximum standard
deviation will be that of the riskiest asset.
Diversification is the key to constructing a portfolio
Diversification
How do we Diversify according to MPT?
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Select assets which are not affected the same way by
similar events. That is, those investments whose
returns do not correlate with each other.
Correlation: Statistically determined and measured
by the correlation coefficient (r). It is the extent to
which variables move in concert; (r) has a range from
-1.0 (perfect negative correlation) to +1.0 (perfect
positive correlation). A value of zero means no
correlation exists between the variables.
Correlation
Look at a Two-asset Portfolio Standard Deviation.
Each asset has a mean return (μ) and a standard deviation()
and you mix the assets in some proportion (from 0% to 100%
or 0 to 1.0). The mean return is linear:
Return = [a x μ1] + [(1-a) x μ2]
but the standard deviation is not linear. It is:
12 = [a2 12 + (1-a)2 22 + (2 a) (1-a) (1 )( 2 )( r12)]
1/2
Correlation
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As the correlation decreases from 1 to something less
than 1, the total standard deviation decreases, in
effect reducing the overall portfolio risk.
Note what happens if the correlation coefficient is
zero or negative.
What are the implications?
Two Assets
Two Assets
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Correlation of +0.4
Two Assets
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Correlation of 0
Two Assets
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Correlation of -0.8
The Efficient Frontier
Developed by Markowitz, an efficient portfolio gives
the highest return for a given risk level, or a
minimum risk for a given return. Values below the
frontier are a feasible set, but not as good as those
lying on the frontier. Anything above the frontier is
not feasible.
Modern Portfolio Theory (MPT)
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MPT assumes investors are risk averse or low risk
investors.
Portfolio risk can be reduced more by investing
internationally in the same industry than by
diversifying across industries within one country.
There is greater risk reduction if you diversify across
industries, across countries and across asset classes.
Risk Adjusted Performance
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What we look for with MPT are the
highest risk adjusted returns. We find
these using Sharpe & Treynor
Measures, as well as with Jensen’s
Alpha.
Sharpe Measure
Return of Portfolio – Risk Free Rate
Sm = -----------------------------------Standard Deviation
Treynor Measure
Return of Portfolio – Risk Free Rate
Tm = -----------------------------------Beta
What is the difference between the two?
Jensen’s Alpha
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 = (portfolio return -Rf) -[(beta) *(Market return Rf)] or, written another way:
 = Portfolio Return – Expected return (per CAPM)
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An  greater than 0 means the portfolio earned an excess
return above the required rate, given its systematic risk (as
determined by Beta).
Traditional Portfolio Management
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Balance the portfolio by mixing a wide variety of stocks and
bonds.
Diversify across many industries and use ratio analysis, dividend
growth models, dividends and earnings analysis, etc. when
choosing securities for the portfolio.
Tend to invest in more blue-chip companies because:
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They are stable and will most likely stay around.
They pay dividends.
Their shares are more marketable and are available in larger
quantities.
They have proven management
They have earnings
Words to Live By?
1. Figure out what a company is worth.
2. Determine how much the stock market is asking for
the business.
3. Invest based upon the difference between 1 and 2.
4. Wait for the market to realize and correct its mistake.
Stock Values
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Par Value - the stated or face value of the stock. There is no
real meaning except in some complicated circumstances.
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Book Value - Represents the amount of shareholder equity in
the firm. It is assets minus liabilities and preferred stock.
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Market Value - Price of a stock in the market. What the
market thinks a share is worth.
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Market Capitalization - Market price x shares outstanding.
Dividends and Capital Gains
Types of Dividends
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Cash Dividends - Dividends paid in cash to holders of record.
This is treated as ordinary income to the person receiving the
dividend.
Stock Dividends - Dividends paid in the form of additional
shares of stock (e.g., a 20% stock dividend means your 100
shares will now be 120). The downside is that the market value
of the shares will typically be the same; the stock price will
adjust for the dividend. The upside is that there is no tax until
the stock is sold.
Dividends and Capital Gains
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Stock dividends change the equity section of the
balance sheet. They cause a transfer from retained
earnings to common stock and paid in capital.
Stock dividends indicate to investors that earnings
are being retained for future growth.
Stock Splits
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Increases or decreases the number of shares
outstanding by giving the holder a certain number of
shares for each share the holder owns.
Stock splits can be used to enhance a stock's trading
appeal by lowering the market price (or raising the
price if a reverse split).
Stock splits do not change the equity section of the
balance sheet, other than the par value of the stock.
Dates to Remember
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Declaration Date - Public announcement that a dividend will
be paid. The company will also announce at this time the
holder of record date.
Holder of Record Date - Date on which an investor must be a
registered shareholder to be entitled to receive a dividend.
Ex-dividend Date - The first day the stock no longer carries
the right to the dividend. This is three business days prior to
the holder of record date.
Payment Date - Actual date when the company mails dividend
checks to holders of record.
Interest Rates
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The return on debt capital
Rate = Real rate + inflation premium + default risk
premium + liquidity risk premium + maturity risk
premium (term premium)
Risk Free Rate (Rf) = Real Rate + Inflation Premium
Technical Analysis
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Looks to predict short-term price movements based
on past price movements. These movements can be
based on several factors:
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Supply and demand.
Irrational and rational behavior or investors (Greed
and panic).
Trends in stock prices over time.
Shifts in supply and demand which changes a
trend.
Common Stock Valuation
Common Stock
Equity capital. Each share entitles the holder to an
equal ownership position, the right to earnings and
dividends, an equal vote and an equal voice in
management.
Fundamental Analysis
Applies formulas and/or ratios to determine the value
of a stock, either on an absolute or relative basis.
An investor can then compare the value to the market
price to determine if the stock is selling at a premium
or a discount. The value can also be compared to
the required rate of return of the investor to
determine if it should be included.
Information Gathering
Where do we find the information we need to
make the right decisions?
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Balance Sheets
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Income Statements
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Cash Flow Statements
Balance Sheet
The statement of a company's assets,
liabilities and shareholders equity.
Assets = Liabilities + Equity
Income Statement
Operating results of the firm. It is a
summary of the amount of revenues, cost
and expenses incurred and the company's
profits incurred over a period of time.
Cash Flow Statements
Provides a summary of the firms cash flow
and changes in cash position
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Cash from operations
Cash from investing activities
Cash from financing activities
Cash flow from operations is the amount of
money a company actually takes in as a result of
doing business.
Using Financial Ratios
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Price to Book Value =
Price / (assets – liabilities – preferred stock), or
Price / shareholder equity.
This is the value determination if the company went
bankrupt today and the assets were liquidated to
shareholders.
Liquidity Ratios
Current Ratio =
Current Assets / Current liabilities
Can the firm cover its current liabilities with current assets?
Quick Ratio (or acid test ratio) =
(Current Assets-Inventory) / Current Liabilities
Excluding inventory can the firm cover its current liabilities with
current assets. Why is this important?
Activity Ratios
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Inventory Turnover =
Annual Sales / Inventory
Total Asset Turnover =
Annual Sales / Total Assets
Leverage Ratios
Times Interest Earned
Earnings Before Interest and Taxes / Interest Expense
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This is the ability of the company to meet its
interest payments in a timely fashion. Important?
Leverage Ratios
Debt to Equity Ratio
Long-term debt / Stockholders' Equity
This is $ of debt for each $ of equity in the capital
structure. When is this good or bad?
Profitability Ratios
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Net Profit Margin = Net Profit / Total Sales
Return on Assets (ROA) = Net profit / Total Assets
or:
ROA = Net profit margin x total asset turnover
Return on Equity (ROE) = Net profit / total equity
Or by manipulation
ROE = ROA x (Total assets / Total equity)
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Fundamental Analysis
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Price to Earnings Valuation (P/E)
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This method looks at the price of the stock and the earnings
per share, either on a historical, a present or a projected
basis.
If a stock has a P/E of 20, an investor can expect a $1
increase in earnings per share to equate to a $20 increase in
the market price of the stock.
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Can project an EPS by taking book value and multiplying it by
Return on Equity.
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PEG Ratios -- The latest P/E relative to the 3-5 year rate of
growth in earnings. When investing, look for lower ratios. WHY?
Payout Ratio
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The ratio of how much of a company’s earnings are
paid out in dividends:
Payout Ratio = Dividends per share / EPS
Valuations
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Constant Dividend Model
Vo = D / r
Constant Dividend Growth Model
V = D (1+g) / (r - g) and r = [D(1+g) / P] + g
Variable Dividend Growth Model
V = PV of future dividends + PV of price of stock at end of growth
How do we determine growth of dividends?
Dividend Growth
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Dividend Payout = 1 – retention rate, so if a
company has a retention rate of 75%, it will pay out
25% as dividends.
Therefore, take ROE and multiply it by retention rate
to get growth rate.
Another is to take past dividends and project the
same rate going forward.
Combination of CAPM and Dividend Growth
RAE Pencil Company, maker of fine #2 pencils used on
SATs country-wide, sells for $27 on the New York Stock
Exchange. Its annual dividend payments have grown
from $1.25 per share 5 years ago to an annual dividend
of $1.65 now. The stock has a  of 0.8.
If the market returns are 9% and the risk-free rate is
3%, what is the required rate of return, the intrinsic
value and the expected return for this stock?
Combination of CAPM and Dividend Growth
Ri = Rf + (RM -Rf) 
= 3 + (9 – 3) 0.8 = 3 + 4.8
Ri =7.8 %
Using Dividend Growth (calculated to be 5.71%)
V = D (1 + g) / (r-g)
= 1.65 (1+0.0571) / (0.078 – 0.0571)
V = $83.46 per share ($21.15 if dividend didn’t grow)
Re = {D(1+g)/P} +g
= {1.65 (1+0.0571)/27} + 0.0571
Re = 12.17 %
Dividend Growth Without CAPM
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Total Assets - $50,000,000
Total Equity - $25,000,000
Net Income - $3,700,000
EPS - $5.00
Dividend Payout Ratio – 40%
Required Return – 12%
What is the Stock’s Value?
Dividend Growth Without CAPM
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ROE = Net Income / Equity = $3,750,000 / $25,000,00
0.15 or 15%
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Growth Rate = ROE x rr = 0.15 x (1 - 0.40) = 0.09 or 9%
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Dividend = EPS x payout ratio = $5.00 x 0.40 = $2.00
D (1+g)
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$2.00 (1 + 0.09)
Value = ----------- = -------------------- = $72.67
r–g
0.12 - 0.09
=
Fundamental Analysis
Dividends and Earnings Evaluation
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Stock is evaluated as the PV of future dividends plus
the PV of the price of stock at date of sale (i.e., you
have a certain period in which you will hold, then
sell).
Problem
Problem Solution
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Required Rate of Return (CAPM):
Rr = 5.5 + [(15.0 – 5.5) 1.3 ]
= 17.85% (~ 18%)
PV = PV (3 years of Dividends) + PV(Stock Price after 3 Years)
= $0.15 + $0.17 + $0.17 + $56.76
= $57.25
Should we buy it? What are the risks?
Summary
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Is there a right way to invest?
How dedicated are you going to be?
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Will you do your homework?
Will you know when to get out?
Will you know when to let ‘em run?
Do you expect to beat the market?
Food for Thought
Studies have been done that show:
1.
As Mutual Fund fees increase, Sharpe
Ratios decrease.
2.
As Mutual Fund Turnover increases,
Sharpe Ratios decrease.
Any Opinions?