Chapter 5 – Portfolio risk and return

Correlation

Correlation is a statistical measure of the co-movement between two numbers and is denoted by the Greek letter rho (r). The correlation coefficient is between -1 and +1. Perfect positive correlation (r) implies that the two numbers always move in the same direction – as one number increases, the second number always increases. Perfect negative correlation (r) describes two numbers that always move in the opposite direction. If correlation equals zero, there is no relationship between the numbers – they are independent.

Investment opportunity set

The investment opportunity set shows all of the available combinations of risk and return when securities are combined in a portfolio. When portfolios are formed with only two securities (assets I and J), the investment opportunity set is a line on a risk/return graph. If the correlation between the securities is +1, the investment opportunity set is a straight line between securities I and J. If the correlation between the securities is -1, the investment opportunity set intersects the vertical axis, meaning there is a specific combination of the two securities which eliminates risk completely. Typically, the correlation between securities is positive but less than +1. The investment opportunity set in this case is a curve.

Diversifiable risk

This is also known as nonsystematic risk, firm specific risk, and unique risk. This portion of an investment’s risk results from events that are unique to the individual security. Since this risk is unique to it a specific security, it’s correlation with other securities is less than +1. Adding more securities that are less than perfectly correlated with the rest of the portfolio yields diversification benefits.

Systematic risk

Also known as market risk or beta risk. This portion of an investment’s risk is attributable to forces that affect ALL investments. Since market risk affects all securities, it cannot be diversified away.

Diversification

A technique that is used to lower the overall risk in a portfolio. Diversification works best when combining assets that have low correlation with the rest of the portfolio. Diversification benefits are achieved when adding securities that are less than perfectly correlated with the rest of the portfolio. Diversification works because firm specific risk is less than perfectly correlated among all investments in a portfolio. However, market risk cannot be diversified away since it is inherent in all securities.

Beta

This is a measure of the amount of market risk inherent in an individual security. Bet is a relative measure of systematic risk where the beta of the market (i.e., the average security) is defined to have . An alternative interpretation is that beta is the sensitivity of the individual security’s returns to changes in the market. Cyclical companies are highly affected by the state of the economy. Therefore, cyclical companies returns are more volatile than the average security and . On the other hand, defensive companies are not as volatile as the overall market and therefore defensive companies have . Beta is estimated by measuring an individual security’s returns relative to the returns on the market. To measure this sensitivity, we must run a regression.

Capital asset pricing model (CAPM)

CAPM determines the returns that investors demand based on the risk inherent in a particular security. CAPM is a specific form for the risk-return tradeoff in finance. CAPM says that investors should not be compensated for taking on firm specific risk since it can be diversified away. The only relevant risk according to CAPM is market risk as measured by beta. The specific form of the risk-return tradeoff is linear – the more risk a security has (as measured by beta) the higher the return.

Market risk premium (MRP)

The market risk premium is the excess return that the average security earns over and above the risk free rate (). The market risk premium is one way to assess the level of risk aversion of the entire market at any point in time. When the market is very risk averse, they require a significantly higher return in order to place their money at risk. In these cases the market risk premium increases.

Security market line (SML)

A graph of the capital asset pricing model equation. The security market line illustrates the required return demanded by investors based on the amount of risk inherent in a security. After determining the return that investors demand (or want), securities are analyzed to estimate what the expected return of the stock might be based on a company’s prospects. Finally, investors compare the required return vs. what they expect security to earn. When securities plot above the security market line, it more than adequately compensates investors for the risk embedded in the security. When securities plot above the line, it is a good investment or said another way, it is undervalued by the market. Securities that fall below the SML are bad investments and should be sold.

Modern portfolio theory

This is a two step approach that is used to determine the optimal portfolio for individual. In step one, we determine the efficient frontier which determines the best portfolios in terms of risk and return. In step two, we overlay an investor’s indifference curves to determine which portfolio on the efficient frontier is optimal for that particular investor.

Efficient portfolio and efficient frontier

An efficient portfolio provides the highest possible return for a given level of risk or equivalently has the lowest level of risk for it given level of return. There are no feasible portfolios that are superior to an efficient portfolio for a given level of risk or return. The efficient frontier illustrates all of the efficient portfolios for any given level of risk.

Indifference curves

An indifference curve illustrates the risk and return tradeoff for an individual investor. A single indifference curve indicates the additional return required to take on additional risk to leave the investor as happy as before. Each indifference curve shows a constant level of utility (or happiness) for a particular investor. Extremely risk averse investors require a significant extra return for taking on a little bit of risk, which implies that the indifference curves are quite steep. More tolerant Investors only require small additional return for taking on large amounts of risk which leads to relatively flat indifference curves. There is one indifference curve for every level of happiness for an individual investor. Investors desire to be on the highest indifference curve, that is, the one that is furthest to the northwest on a risk/return graph.

Chapter 6 – Fundamental analysis of stocks

Fundamental analysis

The study of the financial affairs of a company or security for the purpose of better understanding its future prospects. With fundamental analysis, investors try to understand all aspects of a business, from the management to its products to its current financial condition. In essence, fundamental analysis is learning as much about a company as possible to help understand what its future prospects may be.
One common approach in fundamental analysis is a top-down approach which begins with the general assessment of the overall economy. Understanding the macro economy helps identify conditions that can affect specific industries. Following a macro economic analysis, fundamental analysis begins to refine its focus and look at specific industries, noting key issues that are highly relevant to businesses in that industry. Finally, analysis is concentrated on specific companies. Analyzing a specific company frequently is done by looking at financial statement analysis or ratios to assess an individual firm’s financial condition.

Balance sheet

Also known as the statement of financial position. The left hand side of the balance sheet shows the assets owned by the company, or what the company owns. Assets are what the company uses in its operations to produce cash flows for investors. The right hand side of the balance sheet shows how the company financed those assets. Liabilities and equity are different types of claims on a company’s assets or how cash received from assets is distributed to those who contributed to pay for the assets.

The balance sheet shows the financial condition of a company on a specific date – it is a snapshot of the company on one date. In general, assets are shown in order of liquidity, or the order in which the assets are expected to generate cash for investors. Liabilities and equity shown in the order in which investors line up to lay claim on the assets and income of a company.

The accounting identity shown on the balance sheet is that assets equal liabilities plus equity (A=L+E). The values of the assets, liabilities, and equity are based on a book value basis or historical cost.

Income statement

The accounting identity on the income statement is revenue minus expenses equal profit. Whereas the balance sheet shows the financial condition of the company at one point in time, the income statement indicates financial performance over an entire period, such as a year, a quarter, or a month.

Cash flow statement

The bottom line of the income statement is net income or profit. However, there are several differences between accounting profit and cash. For example, depreciation is an expense that reduces the reported accounting profit on the income statement. However, depreciation is not a cash expense, but rather an accounting convention – spreading the cost of a fixed asset over its useful life. Another difference between cash and profit is when sales are made using credit. The sale increases net income, but since the customer is using credit we have not received the cash from the sale.

The cash flow statement tracks changes in cash and is organized in three sections. (1) Operating cash flow adjusts net income for noncash items (such as depreciation) and other items (such as changes in current assets and current liabilities). (2) The second section in the cash flow statement is investing cash flows, which shows the net effects of buying and selling fixed assets. Growing companies typically are expanding operations and buying fixed assets; therefore, investing cash flows are frequently negative for growing companies. While the income statement reflects annual depreciation charges for fixed assets, the cash flow statement shows the actual upfront outlays associated with purchasing fixed assets. (3) The final section of the cash flow statement is financing cash flows, detailing the company’s use of borrowing and/or issuing new stock securities. Often, growing companies need external financial to pay for their investment in fixed assets so financing cash flows are positive.

Liquidity ratios

Liquidity ratios show the ability of the company to meet its short term obligations. Two common equity ratios are the current ratio and the quick ratio.

Asset management ratios

These ratios determine the ability of management to use assets in an efficient manner. Since ultimately investors have to contribute funds to purchase assets, good managers create more sales from fewer assets. Examples of asset management ratios are total asset turnover, inventory turnover, fixed asset turnover, and days of sales outstanding.

Debt management ratios

These ratios determine how effectively debt is being used by an organization. In order to understand the appropriate use of debt, we must understand first the amount of debt that the company is using. This is determined by the debt ratio, the debt to equity ratio, or the equity multiplier. After we understand the amount of debt the company uses, we need to evaluate how well the company is meeting the interest expense on its outstanding debt. The TIE (times interest earned) ratio evaluates the number of times that interest expense can be paid by the operating income of the company.

Profitability ratios

These ratios help investors understand how all of the operations of a company translate to the bottom line, or the net income of the company. Companies that manage their expenses (including operating costs, interest expenses, and taxes) have higher profitability ratios. Three profitability ratios include net profit margin, return on assets, and return on equity.

Dupont analysis

Also known as ROE decomposition. Dupont analysis helps managers determine the drivers of ROE.
Once the manager has calculated that three separate ratios, they may do a more focused analysis on the areas of the company that lag behind either an industry or a key competitor.

Chapter 7 – Stock valuation

Par value (of stocks)

The par value of stock is no longer a very useful concept. At one time, the par value was the initial offer price and the issuing company agreed to not offer additional shares below the existing par value. In this way, investors could be sure that future shareholders would not receive a better price if the company offered more stock. Nowadays, companies and the financial markets are closely scrutinized by the Securities and Exchange Commission so that investors can feel more confident when buying new shares of stock. Most stocks today do not have par values, or if they do, they are ridiculously low (such as one penny).

Book value of equity

The book value of equity per share is calculated by taking the common equity value shown in the balance sheet and dividing by the number of shares outstanding. Book value refers to the amount that is shown in the financial statements which is typically based on historical cost. The balance sheet shows the accounting identity . Solving this equation for equity, . Given that assets are recorded based on historical cost, it is likely that the book value of assets shown on the balance sheet grossly underestimates the true market value of those assets. As a result, the book value of equity is a poor estimate of the true market value of the company. In some instances, it may be considered a worst case, lower bound for a company’s stock price.

Intrinsic value

Refers to the present value of future cash flows of an investment. To determine intrinsic value, investors need to make assumptions about: future cash flows and the required discount rate.
Based on these assumptions, the intrinsic value tells the investor what the investment “should” be worth. To determine whether an investment should actually be purchased, the investor compares his estimated intrinsic value with the actual market price. If the investment can be purchased at a lower price than the investor believes it is worth as predicted by intrinsic value, he or she should purchase the investment.

Market value

This is the price that investors are currently paying for a particular investment. It is likely that the overall market is making different assumptions about the future cash flows of an
investment and/or its risk. Therefore, an individual investor’s estimate of intrinsic value is likely to be different than the value actually paid by the market.

Dividend discount model (DDM)

DDM is an approach that is used to determine the value of the stock by discounting all dividends that are expected to be paid in the future. Since stocks have no stated maturity date, this requires investors to project dividends forever. The discount rate is based on an assessment of the stock’s risk, commonly estimated using CAPM.

Constant growth dividend discount model or the Gordon model

The Gordon model is a specific case of the DDM where dividends are expected to grow at a constant rate (forever. Mathematically, the infinite series of discounting all future dividends collapses to a simple formula:
There are several implications of the Gordon model:
1. The growth rate of the stock, or the capital gains yield, is the same as the rate of growth of dividends (.
2. If all transactions take place at the intrinsic value, the total expected return earned by the investor (including dividend yield and capital gains yield) is equal to the return required by the investor ().
The most difficult value to estimate in the Gordon model is growth rate of dividends. The Gordon model works well for companies that are in mature markets whose rate of growth is similar to the rate of growth in the overall economy.

Sustainable growth rate

This is a calculation that determines how much a company could comfortably grow if it reinvests profits back into the organization. Since ROE is a measure of the (accounting) rate of return on a business, the sustainable growth rate is determined by considering the percentage of these profits that are reinvested back into the company.

Multi stage dividend discount model

Since many companies do not exhibit constant growth, the Gordon model is inappropriate for valuing their stock. Frequently, new companies grow rapidly at first, then growth slows as the company’s products and industry matures. The multi stage DDM still attempts to find the present value of all future dividends. But instead of assuming that these dividends increase at a constant rate forever, the multi stage DDM uses two distinct stages: Super normal growth phase – during a company’s early formative stages, it is experiencing rapid growth in dividends.
Constant growth phase – a company cannot continue to grow at a rapid rate forever. At some point in the future, the company’s products will have saturated the market in which case growth must slow down. When the company matures, it is assumed to enter the constant growth phase.

To calculate a stock price under the multi stage DDM, follow three steps:
1. Project dividends through the super normal growth phase
2. To determine the value of the dividends during the constant growth phase, calculate the stock’s terminal value or horizon value
3. Discount steps 1. and 2. (above) at the stock’s required rate of return.

Dividend payout ratio

There are two things that companies can do with earned profits: pay them out as a dividend or reinvest them back into the company. The percentage of profits or earnings that are distributed to shareholders as cash dividends is called the dividend payout ratio.

Retention ratio (or plowback ratio)

Instead of paying dividends, the retention ratio is the percentage of profits or earnings that a company reinvests back into the organization.

P/E ratio

The P/E Ratio is a measure of how much investors are paying for each dollar of current profit.
The P/E ratio summarizes the market’s view of the projected growth of the company. To see this, note that shareholders are the residual claimholders of a company, receiving any profits that are left. If investors believe this residual claim is going to grow rapidly because of a company’s future performance, they will be willing to pay more for the stock per dollar of current income. If a company’s profits are expected to be stable or even decline, investors will pay less for the stock.

PEG ratio

The P/E ratio is a measure of market perceived growth. As people perceive a company’s growth rate to increase, so does the price of the stock and consequently its P/E ratio. Investors may check the relationship between market perceived growth as proxied by the P/E ratio and the company’s actual growth rate using the PEG ratio.
If the PEG is too high, the P/E ratio may not be justified since actual earnings growth is low.

Chapter 8 – Technical analysis

Technical analysis

Technical analysis uses price movements and volume data to assess market sentiment about a particular stock or the overall market. Technical analysts do not attempt to find the intrinsic value of a stock and they ignore the underlying business of companies or its products. Instead, they focus on supply and demand forces that have historically affected the market for a stock.

Dow theory

One of the earliest forms of technical analysis, Dow theory suggests that the overall market has three specific trends. The primary trend is the market movement over long periods of time. Secondary trends move against the primary trend but are only temporary in nature – overall the market is still moving in the primary trend direction. Finally, tertiary or daily fluctuations in the market are irrelevant. The goal of Dow theory is to identify the primary long-term trend.

Arms ratio or trin

A technical indicator that incorporates volume to weight the importance of price movements. Technical analysts argue that price moves with heavy volume are more important than price movements with light volume. The Trin ratio is one approach to incorporate volume into a technical indicator. If Trin > 1.0, then people were trading more heavily in the stocks that declined in value indicating a bearish training session. If Trin < 1.0, then people were trading more heavily in stocks that advanced indicating a bullish trading session.

On balance volume (OBV)

A cumulative measure of the market sentiment of a stock that incorporates the volume of trades. Each day, if the stock price INCREASES, the volume of that day is ADDED to the cumulative OBV. If the stock price DECLINES during the day, volume is subtracted from OBV. Market sentiment is measured based on the trend in OBV.

Market breadth

A simple comparison of the number of stocks advancing versus declining on any particular day.

Advance/decline line

A measure of cumulative market breadth. Instead of looking at market breath on any one particular day, the advance/decline line accumulates the net advancing shares (the number of advancing stocks minus the number of declining stocks) over time. Technical analysts then look at the trend in the cumulative advance/decline line to make an assessment of market sentiment.

Short selling

A strategy that is designed to profit from falling stock prices. To short sell a stock, one must borrow shares from another investor and sell them in the marketplace. Later, the investor must go back into the market to repurchase shares and return them to the lender (called covering their short position). If the short seller can sell the securities at the start of the transaction at a higher price than they cover their short position, they will earn a profit. In other words, they profit when the stock price falls.

Odd lot

A trading order of less than 100 shares, i.e, less than a round lot. Most odd lot transactions are done by small investors.

Line chart

A graph of stock prices which simply connects the closing stock prices at the end of each period (typically daily prices).

Bar chart

A graph of stock prices. For each period, the top of the line indicates the highest trading price during the trading period, the bottom of the line indicates the lowest trading price of the period, a tick mark pointing to the left of the line indicate the opening price during the period, and a tick mark to the right indicates the closing price for the period.

Point and figure chart

Unlike line charts and bar charts, the point and figure chart has no explicit time dimension. Using X’s to indicate increasing prices, point and figure charts track only significant price moves in a specific stock. O’s each column in a point and figure chart shows a price reversal.

Moving average chart

Instead of graphing the closing price on each day, the moving average takes the average closing price over a number of days. The point of moving averages is to downplay any specific day and smooth out daily fluctuations. When more days are included in a moving average, you get a smoother resulting line. Shorter moving averages follow the daily prices more closely and are more volatile than longer moving averages.

Support level

A support level is an apparent or perceived lower bound for the price of a stock. Each time the stock price approaches the support level, it appears to bounce away from that price. Technical analysts argue that support levels represent underlying demand for a security when a stock price falls too low. At that point, technical analysts argue that investors’ recognize that the stock surely has value at the support level. The buying pressure that results forces prices up.

Resistance level

A resistance level is an apparent or perceived upper bound for the price of a stock. As the stock price rises, traders in the market believe the fundamentals of the company do not justify a
higher price than the resistance level. As a result, a flood of sell orders come to the market depressing the stock price. Technical analysts argue that stock prices have a difficult time breaking through the resistance level.