Chapter 3: Investment Approaches

This chapter looks at strategies used by investors in identifying securities to buy or sell.
Investment strategies therefore are the methods or techniques used by investors and analysts
before investing their funds in different securities or shares. As such they are used to identify
securities to buy and sell at any given time. The approaches include:

Investment strategies

Technical Analysis Fundamental Analysis Momentum Strategies Efficient Market

Hypothesis

Relative Strength Contrarian Investment

Strategy Strategy

Technical analysts/chartists use historical data of shares which are past movements of shares
and its values. They believe on the notion that history has a tendency of repeating itself. With
relative strength strategy, investors buy winners and sell losers whilst the opposite is true for
contrarian strategies where investors buy losers and sell winners.

NB: The techniques should be viewed as complimentary to each other as investors and
analysts should mix the various aspects of these strategies before making investment
decisions or recommendations.

a) Technical analysis
The approach emphasizes that the behaviour of the price of a share and the volume of trading
determines the future price of the share. It centers on the plotting of the price movement of
the share and drawing inferences from the price movement. This technique is used by
investors/analysts who believe that by carefully analyzing historical data of shares
traded(price movements and volumes),future prices or direction can be predicted with
confidence thus inform appropriate investment decision as history has a tendency of repeating
itself. The logic of the approach is that by carefully analysing historical movements of shares,

1
a pattern can image which can then be used as a basis for making current investment
decisions on whether to buy or sell a particular share now.

The primary advocates of this investment approach are veteran market analysts or investors
who have spent many years observing the market and its patterns. Their justification of this
approach is that the best indicator of the market is the market itself, as result investors:
(i) Should not tell the market what it should be but let the market tell you as an investor.
(ii) Investors should not fight the market but rather listen to the market

Technical analysis is the most controversial type of approach but without doubt there are
aspects which are valid and some which seem controversial. The best approach is therefore to
take the valid aspects and ignore the controversial once when making investment decisions.
Some of the aspects which are generally acceptable include analysis of advances and
declines, 52 weeks highs and lows, moving averages, pivot point prices, odd lot trades
and money flows.

Technical analysis factors/indicators

Basically there is no limit on the number of technical market indicators which could be
employed by investors to make investment decisions but some of the commonly utilized
include:

(i)Advances and Declines.

This involves looking for the number of stocks increasing in prices which are referred to as
advances and those decreasing in prices which are known as declines. If the number of
advances exceeds a number of declines (A>D), it is taken as a bullish signal and investors
should prepare to sell their shares. On the other hand ,if advances are less than declines
(D>A),it is indicative of a bearish signal thus investors should prepare to buy stocks since
we buy low and sell high.

(ii) 52 Week Highs and Lows.

This is when the highest and the lowest prices of shares for the previous year (52 weeks) are
used to provide a frame of reference /standard (trading range) to help investors establish
whether a particular share in the current period is relatively cheap for acquisition or
expensive so as to sell. As a result, a share trading closest to its 52 week lowest price is
2
deemed cheap and thus a bargain and should be bought and the reverse is true. An
increase in new highs would indicate a bullish signal thus investors should prepare to
sell and the opposite is true.

(iii)Moving Averages.
This uses a 50 and 200 day moving averages for a share as benchmarks/standards to
determine whether the share in the current period is relatively cheap/expensive /underpaid or
overpriced. If a particular share is trading below its moving average in the current period it is
deemed to be underpriced/undervalued and thus should be bought and the opposite is true

(iv)Pivot Point Prices (PPP).

It is a price level of significance under technical analysis that is used by traders or investors
as a predictive indicator of market movement. A Pivot Point Price is calculated as an
average of all significant prices (lowest, highest and closing prices) from the performance
of a company in the previous or prior period. If the company’s shares in the current
period trades above the pivot point price, it becomes an indicator of a bullish signal of
statement thus investors should prepare to sell and the reverse is true. Therefore entering
the market at this level (PPP) ensures that the odds of success are greater than that of failure.

(v)Odd Lot Trades (OLT).

O.L.T are “buys”/ “sells” made by small investors normally buyers of a few hundreds of
shares who are viewed by other market participants or players as notoriously late into and out
of the market. An increase in the number and volume of trade in odd lots is viewed by many
players as a Contra Indicator (against indication). For example if there is an increase in
Odd Lot Trading during a bullish season, it may mean that the season is over or the rally is
over and normal players should stop selling.

(vi)Money Flows.
This is a technical market indicator that keeps a running total of money flowing into and
out of a share. Increasing money flow is indicative of increasing demand for the share and
should see the price rising ceteris paribus, thus investors should prepare to sell. On the
other hand decreasing money flow is indicative of fallen demand for the share which should
result in the price falling and thus investors should prepare to buy.

3
b) Fundamental Analysis.
This investment approach involves the process of looking at the basics/fundamental level.
Fundamentalists thus believe in analysis of publicly available current information such as
published financial results, cautionary statements and any other relevant information
pertaining to the listed companies as well as usage analysis for investment ratios. The
advocates of this approach believe that by carefully analyzing publishes financial results and
other relevant information, investors and analysts are able to identify Undervalues
(attractive) or Overvalued shares thus the decision to either buy or sell. Undervalued shares
once identified are bought with the anticipation that they will be sold once the market
corrects itself and the reverse is true for overvalued shares.

In light of the above fundamental analysis also involves usage of various investment ratios in
order to determine the financial health of a company as well as to get an idea of the Intrinsic
Value (Net Asset Value)/true value of the share in question. The N.A.V is then compared to
the market value to establish whether a share is underpriced, overpriced or correctly
valued

 Thus if the (N.A.V > the market price), this means the share is undervalued
therefore the decision is to buy the share.

 If the (N.A.V <market price), the share is overpriced therefore the decision is to
sell.

 If the (N.A.V = market price), the share is correctly priced therefore one can
either buy or sell.

NB: Therefore the main purpose of fundamental analysis is to determine whether a share is
cheap or expensive as compared to its time value or intrinsic value.

Fundamental analysis also involves analysing the firm’s fundamentals (basis) e.g.
profitability, liquidity, capital gearing, growth prospects, market valuation etc. These factors
are then compared with those of other players in the same industry in order to establish
whether the company is performing above or below competition and hence the decision to
buy or sell.

4
Important Investment Ratios under Financial Analysis.

(i) Earnings Per Share (EPS) = Profit After Tax

Number of Ordinary Shares Issued

(ii) Dividend Payout Ratio = Dividend Per Share

Earnings Per Share

E.g. If EPS is $5, and DPS is $2, DPR = 40% implying that for every dollar generated, 40%
is generated per share.

(iii)Dividend Cover.
This shows how many times a company can repeatedly declare dividends before it runs into a
loss.

Found by: Earnings Per Share NB: the answer is given in times
Dividend Cover

(iv)Interest Cover.
The higher the interests cover the healthier the company is and the more attractive it is
= Earnings before Interest and Tax (EBIT)
Interest Payable

(v)Capital Gearing Ratio.

This measures the extend at which a company is financed by debt

= Debt X 100
Debt + Equity 1

NB: If Debt is 55m and Equity is 45m, Gearing Ratio will thus be 55%

5
Efficient Capital Markets.
An efficient capital market is one in which security prices reflect available information.

Types of Efficiency.
Three types of market efficiencies can be identified and these are now explained.

(i) Operational Efficiency: This refers to the cost of security transactions to buyers and
sellers on the exchange. It is desirable that the cost is as low as possible and creating a
lot of competition between market makers and brokers can bring this about.

(ii) Allocation Efficiency: This refers to the ability of the stock market to direct financial
resources where they are most needed. Society’s financial resources are scarce so it is
important that this scarce resource is allocated where it is most productive. Stock
markets assist in the allocation of the scarce financial resources between competing real
investments.

(iii) Pricing Efficiency: The market price of a share should reflect available information so
that no investors can earn returns above those earned on average by the market. The
ability of the market to correctly price a financial security is what is referred to as
pricing efficiency. It is the efficiency to focus on when dealing with the efficient market
hypothesis.

Importance of having an Efficient Market

It is desirable that the stock market operating in an economy is efficient. There can be
substantial benefits to be derived from this efficiency. These benefits are now discussed.

(i) An Efficient Market Encourages Share Buying: Accurate security pricing is

important if investors are to invest in quoted companies. The investor wants an
assurance that securities are correctly priced. He would not want to lose his hard earned

6
 financial resources. Inability to correctly price financial securities can lead to a shortage
of funds to organizations.

(ii) An Efficient Market Provides Correct Signals To Corporate Management: If

companies are to pursue shareholder wealth maximization, sound financial decision-
making will require that the market correctly price securities. The market will provide
the necessary feedback on their efforts. Unreliable security prices can distort the
investment decision. Share prices provide indication of the required rate of return.
Projects can be wrongly accepted or rejected.

(iii) An Efficient Market Assists In The Allocation Of Resources: Allocation efficiency

requires both operational and pricing efficiency. Assuming an inefficient company has
highly priced shares it would be able to attract capital and the limited resources will be
wasted.

Price Behavior in an Efficient Market.

In an efficient market the price reflects what is known about a company’s current operations,
profitability and potential for future growth and profits

Overreaction and correction

Price ($)
220

180

140
Efficient market reaction
100 Delayed reaction

-4 -3 -2 -1 0 +1 +2 +3 +4
Time in days

Fig. Reaction of share price to new information in efficient and inefficient markets.

Efficient Market Reaction: The share price instantaneously adjusts to and fully reflects new
information. There is no tendency for subsequent increases and decreases to occur.

7
Delayed Reaction: The share price partially adjusts to the new information. Four days elapse
before the share price completely reflects the new information.

Overreaction: The share price over-adjusts to the new information. It overshoots the new
price and subsequently corrects.

Efficient Market Hypothesis (EMH).

This is an investment theory that states that it is impossible to beat the market because prices
already incorporate and reflect all relevant information. Proponents of this model believe that
it is pointless to search for undervalued stocks or try to predict trends in the market through
any technique from fundamental to technical analysis.

Eugene Farma formulated efficient market hypothesis in 1970. The hypothesis suggests that
at any given time, prices fully reflect all available information on a particular stock and or
market. No investor has an advantage in predicting a return on a particular stock price since
no one in particular has access to information not already available to everyone else.

Degrees of Market Efficiency.

The following are three classifications of market efficiency. They reflect the degree to which
efficiency can be applied to markets.

 Strong Efficiency: This is the strongest version which states that all information in
the market, whether public or private is accounted for in the stock price. Not even
insider information could give an investor an advantage.

 Semi-Strong Efficiency: All PUBLIC information is calculated into a share’s current

price. Neither fundamental nor technical analysis can be used to achieve superior
gains.

 Weak Efficiency: This type of efficient market hypothesis claims that all past prices
of a stock are reflected in today’s stock price. Technical analysis cannot be used to
predict and beat a market.

8
Challenges to Market efficiency.
In the real world there are some investors who have beaten the market. Warren Buffet’s
investment strategy of focusing on undervalued stocks made millions and set an example that
is now being followed by many.

There are also consistent patterns that are present in the market. There is the January effect, a
pattern that shows that higher returns tend to be earned in the first four months of the year.
There is also the “blue Monday on Wall Street”. This is a term that discourages buying
stock on Friday afternoon and Monday morning because of the “weekend effect”. This is a
tendency for stock prices to be higher than the rest of the week.

Studies in behavioral finance (a study into the effects of investor psychology on stock
prices) also reveal that there are some predictable patterns on the stock market. Investors buy
undervalued stocks and sell overvalued stocks. Paul Krugman, MIT economics professor,
suggests that because of mass mentality of the trendy, short-term shareholder, investors pull
in and out of the latest and hottest stocks. This leads to stock price distortions and hence the
market becomes inefficient. Prices in this case would be manipulated by profit-seekers.

Contributors to Market Efficiency.

The following can be noted as significant contributors to the improvement of market
efficiency:

1. Investors must perceive that a market is inefficient and possible to beat. Investment
strategies intended to manipulate inefficiencies will actually be the fuel that keeps a
market efficient.
2. A market must be large and liquid.
3. Information must be widely available (in terms of accessibility and cost). It should
also be released to investors more or less at the same time.
4. Transaction costs must be cheaper than the expected profits of an investment
strategy.
5. Investors should have enough funds to take advantage of the inefficiencies until the
inefficiencies disappear.
6. Investors must believe that they can outperform the market.

9
Conclusion.
Efficient market hypothesis supporters argue that profit seekers will exploit abnormalities that
may exist until they disappear leaving the market to eventually correct itself. Large
transaction costs are likely to outweigh the benefits of trying to take advantage of such a
trend.

Markets cannot be absolutely efficient or wholly inefficient; they are a mixture of both. Daily
decisions by market players cannot be reflected immediately into the market.

Electronic trading allows for prices to adjust more quickly to news entering the market.

Information technology is leading to greater market efficiency. It allows for a more effective,
faster means to disseminate information widely. It however restricts the time for the
verification of information used to make the trade. This may eventually result in less
efficiency if the quality of the information no longer allows investors to make profit-
generating decisions.

Implications of the EMH for investors.

1. Public information cannot be used to earn abnormal profits. Fundamental analysis is
therefore a waste of money for as long as efficiency is maintained. The best an
average investor can do is to select a diversified portfolio.
2. There is need for greater volume and timely information. Since semi-strong efficiency
depends on the quality and quantity of publicly available information investors should
pressure companies, accounting bodies, governments and stock market regulators to
produce as much useful information as is possible without jeopardizing company
operations to competitors.

Implications of the EMH for companies.

1. The timing of security issues does not have to be fine-tuned
2. Large quantities of new shares can be sold without materially moving the share price.

Factors contributing to developing stock market inefficiencies.

1. Lack of investment analysts. For the market to be efficient there must be a large
number of competing investment analysts. Competition among investment analysts

10
 ensures that information is instantly reflected in security prices. In emerging markets
there are few analysts and this reduces market efficiency.
2. Few buyers and sellers. There are relatively few buyers and sellers on developing
stock exchanges. Few institutional investors sometimes have a very large impact on
the performance of some shares. This leads to less efficiency since price
determination is only left to a few investors.
3. The Government. Poor or unrealistic government policies have effects on stock
exchanges. In Zimbabwe for example, Socialist policies adopted at independence
impacted on investor confidence leading to a slump in the operations of the exchange
in the 1980s. This outside influence leads to increased inefficiency of the exchange.
The position changed, however, following the adoption of more liberal policies and
this so the exchange being voted as one of the best performing exchanges in the
developing economies.
4. Limited number of traded firms (counters). In many developing states the number of
firms listed on the stock exchange is few compared to the number of firms operating
in those countries. This limited number means that all industries will not be
represented on the exchange leading to problems in analyzing and incorporating
information.
5. Limited information disclosure. There is limited disclosure of information by
companies in developing economies. In Zimbabwe for example, financial reports only
show the minimum information stipulated by legislation. This results in problems in
the pricing of securities, as information is the basis of security pricing.

Insider Trading.
 Insider trading is the dealing in securities or financial instruments by a person knowingly
in possession of inside information, relating to the financial instrument being dealt in.

 Inside information is specific and precise information obtained by an insider, which is

price sensitive and has not been made public.

 Price-sensitive information is information that has a material effect on the price or value
of an instrument if it is made public.

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 An insider is someone who has obtained inside information through being a director,
employee or shareholder of the issuer of the financial instrument, or someone who has
gained access to such information by virtue of his employment, office or profession.

 Insiders can either be Primary or Secondary. Primary insiders obtain information directly.
They include a director, employee, shareholder, legal advisor, auditor, corporate advisor or
sponsoring stockbroker of the company, Secondary insiders are individuals who obtain
inside information directly or indirectly from a primary insider.

NB: Insider trading undermines confidence in the stock market.

Approaches to deal with insider trading.

To avoid undermining the confidence in the stock market it is necessary to deal with insider
dealing. The following approaches have been suggested as ways that could be used to deal
with insider trading.

(a) Legislation and codes of conduct

(b) Increasing the level of information disclosure (Price Sensitive Information).
(c) Prohibiting certain individuals from dealing in the company’s shares at crucial time
periods. This is generally during the reporting season.

================================================================================================

Chapter 4: Valuation of Securities.

Valuation is the process that links risk and return in order to determine or establish an asset’s
worthiness (Correct/Fair Price) In order to correctly value securities, one needs to understand
the nature of future cash flows to be generated by the security during the holding
period/investment period, their timing and uncertainty (Risk) associated with these future
cash flows. The correct price or value of the security is then determined by
converting(discounting) the expected future cash flows to their present values (PVs) using an
appropriate discounting rate that is equivalent to the (RRR) on the particular investment. The
discounted values (PVs) are then summed up in order to get the correct fair price of the asset
in question. As a result, the following steps are applicable when valuing securities:

a) Identification of all future cash flows to be generated by the investment

12
b) Discount or convert the future cash flows (FVs) into their present values (PVs) using an
appropriate discounting rate.
c) Sum/add the present values to get the correct/fair price of the security in question.

NB: The securities that we are interested in valuing are limited to ordinary shares, preference
shares and long term debt securities such as corporate bonds, debenture stock and loan notes.

1. Valuation of Ordinary Shares. NB: (Use Investment Analysis BM204 ‘Table A’)
Ordinary shares do not mature and dividends paid can either be constant, growing at a
constant rate or change always. When an investor invests in ordinary shares, it is either he
buys shares for a fixed period, or buys them to hold them in perpetuity. The valuation models
to be used under these two circumstances do differ.

a) Valuation of Ordinary Shares with zero growth dividends over a fixed period.

Example.
TY Ltd.’s ordinary shares are currently paying a dividend of $30 per share. The dividends are
not expected to increase in the next four years because of stable economic environment. An
investor currently holds 10 000 such shares, his intention is to dispose them at the end of 4
years and realize a dividend yield of 40% at the end of the 4 year period. The required rate of
return (RRR) in similar risk investments on the market is currently 25% per year. Calculate
the correct price of this share.

Step 1:

0 1 2 3 4
$30 $30 $30 $30 $30
+
$75

Do = current dividends therefore not valued

Calculation of Sale Proceeds:

13
Dividend yield = Dividend per share of final year
Market price of final year

0.4 = 30
P

P = $75 per share

Step 2: Discount the Cash Flows

Year Cash Sale Discount Rate Present
Dividends Proceeds @ 25% Per Value
Year
1 30 0.80000 24.00
2 30 0.64000 19.20
3 30 0.51200 15.36
4 30 75 0.40906 42.95
Step 3: Correct/fair price per share 101.51

Present Value = Discounting Rate X Cash Dividends

NB: When cash flows to be received by the investor are fixed, they are called Annuity. Then
use the direct formula to get the same answer

Direct formula:
Correct Price = Cash Dividends X Present Value Interest Factor Annuity @ R, N
= Cash Dividends (P.V.I.F.A.R.N) + Sale Price (P.V.I.F.R.N)
= 30(P.V.I.F.A.25%.4) +75(P.V.I.F 25%.4)
= 30(2.36106) + 75(0.40906)
= 70.8318 +30.6795
= 101.5113
= $101.51

NB: P.V.I.F.A is the summation of the discounting factor of all dividends for the 4 years.

b) Valuation of Ordinary Shares with Constant Growth Dividends over a Fixed Period.

Example
Ordinary shares of Y Ltd are currently paying a dividend of $40/share. However; the
dividends are expected to grow at an annual rate of 10% for the next 4 years. An investor
wishes to dispose his shares at the end of 4 years and earn a 30% dividend yield. What is the

14
correct value of each share if similar risk shares on the market are giving an annual return of
20%?

0 1 2 3 4
$40 $44 $48.4 $ 53.24 $58.56
+
$195.21

Dividend yield = Div. per share in final year

Market price

0.3 = 58.56
P

P = 195.21(Sale price)

D1 = Do (1 +g)
Whereby: Do = Current Dividend
D1 = Dividend Expected in the 1st Year
g = Annual Growth

To get discount use = 1

(1+r) n

Year Cash Sale Discount Present

Dividends Proceed Rate@20% Per Value
s Year
1 44 0.83333 36.07
2 48.4 0.69444 33.61
3 53.24 0.57870 30.81
4 58.56 195.21 0.48225 122.38
Correct/fair price per share 223.47

c) Valuation of Ordinary Shares with Variable Growth Dividends over a Fixed Period
In most situations, companies pay a variable growth dividend that is a dividend with a
variable growth rate. This is because the operating environment or economic environment

15
does changes, thus affecting profitability dividends paid. Such stocks are then valued as
follows:
Example.
The dividends of L Ltd are expected to grow at a rate of 10% in the 1 st year, 12% in the 2nd
year, 15% in the 3rd year and finally 20% in the 4th year. The company is currently paying $50
per share as dividends annually. An investor intends to sell his shares at the end of 4 years
and realise a dividend yield of 35%. Calculate the correct price of this share if required rate
of return on similar risks shares on the market is 18% per year.

D1 = Do (1 +g)
Do = $50
D1 = 50(1, 1) = 55
D2 = 55(1 + 0.12) = 61.6
D3 = 61.6(1 +0.15) = 70.84
D4 = 70.84(1 +0.2) = 85.01

Dividend yield = Div. per share in the final year

Market price

0.35 = 85.01
P

P = $242.89

Year Cash Sale Discount Rate@ Present

Dividends Proceeds 18% Per Year Value
1 55 0.84746 46.61
2 61.6 0.71818 44.24
3 70.84 0.60863 43.12
4 85.01 242.89 0.51579 169.13
Correct/fair price per share 303.10

Follow Up Question
The dividends of Z Limited are expected to grow at a rate of 20% per year for the next 2
years before subsidizing to 16% per year in the 3rd year and finally 12% per year in the 4th
year. The company which is currently paying a $50 per share dividend annually has a
required rate of return of 22%.Calculate the correct price of this share if the investor wishes
to dispose his shareholding at the end of 4years and realize a dividend yield of 40% .

16
d) Valuation of Perpetual (forever) Ordinary Shares
When ordinary shares have no fixed life span, they are valued on the basis of next coming
dividend(D1).As a result ,if dividends are not going to change into the foreseeable future(zero
growth dividends)such ordinary share is valued as follows

P = D1 where by: D1 = is dividend receivable per share after 1 year

ke ke = is the cost of equity

Example.
If current dividend of a company is $20 per share and it has to remain at that level into the
foreseeable future, what is the correct price of this share if similar investment of the market
has a required rate of return of 16% at the market?

P = D1 = 20 = $125 per share

ke 0.16

e) Valuation of Ordinary Shares with Constant Growth Dividends over an Infinite

Investment Period (Gordon Model/Constant Dividend Model)
Dividends on ordinary shares often change over time. The constant growth model is based on
the assumption that dividends grow at a constant rate (g) per annum forever and that rate is
smaller than the required rate of return. Such shares are therefore valued as follows:

Po = D1 or Po = Do (1 + g)
ke-g ke-g

Whereby: D1 = dividend per share receivable after 1 year

g = annual constant growth rate of dividends in decimals
ke = cost of equity (RRR) on similar investment

Example
If dividends just paid $53 per share and these dividends are expected to grow at an annual
rate of 10% forever. Calculate the correct price of this share if similar investments on the
market are giving a return of 30% p.a.
17
Po = Do (1 +g)
ke-g

= 53(1 + 0.1)
0.3- 0.1

= 58.3
0.2

= $291.50

Example 2
A Ltd company has the following dividend history

Year Dividend per share

2017 15.80 D4
2016 14.70 D3
2015 13.30 D2
2014 12.45 D1
2013 11.70 D0

Required
Calculate the correct value of A Ltd’s ordinary shares assuming that the required rate of
return on similar risk share on the market is 35%

D4 = Do (1 +g) 4

15.80 = 11.70 (1 +g) 4

15.80 = 11.70 (1 +g) 4

11.70 11.70

(1 + g) 4 = 15.80
11.70

(1 +g) = 15.80 x 1/4

11.70

1 +g = 4 15.80
11.70

18
 g= 4 15.80 - 1
11.70

g= 0.08

Dividends payable in 2018 therefore will be calculated as

D1 = Do (1 +g)

D 1 = 15.80(1 +0.08)
= 17.06

Therefore P0 = 17.06
0.35 - 0.08

= $63.20

Follow up Question
Z Ltd Company has the following dividend history

Year Dividend per share

2017 3.80 D5
2016 3.62 D4
2015 3.47 D3
2014 3.33 D2
2013 3.12 D1
2012 2.97 D0

Required.
Calculate the correct value of Z Ltd’s ordinary shares assuming that the required rate of
return on similar risk share on the market is 25% per annum

f) Valuation of Ordinary Shares with variable growth dividends over an infinite

investment period.
This model allows for a change in the dividend growth rate in line with changes in the
operating environment. If companies have an influence on dividends to be paid such shares
are valued as follows:

19
Example.
MT Ltd is currently paying a $50 per share. Analysts expect this dividend to grow at 10% in
the 1st year, 12% in the 2nd, 14% in 3rd year, and 15% in 4th year before it drops to 13% the
following year into foreseeable future. Similar risk investments on the market are giving an
annual return of 34%. Calculate the correct value of this share.

NB: Ordinary shares with variable growth dividends over an infinite period are always
valued at the point when dividend growth rate becomes constant forever. At that point the
dividend is equivalent to D1.
Projection therefore of valuation price when dividends become constant D1

Do = $50
D1 = 50(1.1) = 55
D2 = 55(1.12) = 61.6
D3 = 61.6(1.14) = 70.22
D4 = 70.22(1.15) = 80.75
D5 = 80.75(1.13) = 91.25

Po = D1 = 91.25 = $434.52
ke-g 0.34 - 0.13

Year Cash Sale Discount Rate@ Present

Dividend Proceeds 34 % Per Year Value
s
1 55.00 0.74627 41.04
2 61.60 0.55692 34.31
3 70.22 0.41561 29.18
4 80.75 0.31016 25.05
5 91.25 434.52 0.23146 121.69
Correct/fair price per share 251.25

Follow up Question
A company currently pays a dividend per share of $50.However analysts expect this dividend
to grow at 10% per year for the next 2 years before dropping to 8% per year in the 3 rd year
and finally picking up to 12% per year into foreseeable future. The current required rate of
return for similar risk investments on the market is currently 30% per annum. Calculate the
correct value of each company’s ordinary share.

20
2. Preference shareholders
These receive dividends just like ordinary shareholders however they are three major
differences between of preference and ordinary shares.

a) Dividends of preference share are normally fixed at a dollar amount or specified as a

percentage of face value whereas those of ordinary shares are normally fixed.

b) Preference dividends are given preference that is they are paid before the ordinary shares.

c) Preference dividends are either cumulative or non-cumulative in nature. If they are

Cumulative, it means if dividends are not paid out in one period, they are carried over to the
next period as arrears while Non-Cumulative dividends cannot be carried over to the next
period as arrears.

These differences have implications on valuation of preference shares. In addition dividends

on Ordinary Shares are not cumulative in nature. Preference shares can either be Redeemable
(fixed life span) Irredeemable (infinite holding period) and this has implications as different
models are used.

a) Valuation of Redeemable Preference Shares with no arrears (Non-cumulative)

X Ltd would like to sell 200 000, 25%, $200, 4 year redeemable preference shares. Similar
share on the stock market are giving a yield of 10%.Calculate the correct price of each
preference share.

Dividend per share = Preference dividend x face value

= 0.25 x 200
= $50 per share.

Year Cash Sale Discount Rate Present

Dividends Proceeds @ 10 % Per Value

21
 Year
1 50 0.90909 45.45
2 50 0.82645 41.32
3 50 0.75131 37.57
4 50 200 0.68301 170.75
Correct/fair price per share 295.08

The preference share is very attractive because the market is offering 25% to investors yet
they are just getting them just for 10%.
NB: When there is nothing said on the maturity of the dividends, we use the face value e.g.
$200 in this case. Since $50 is an Annuity (fixed stream of income) we can use the direct
formula i.e.
Direct formula:

Po = cash div (PVIFA10%, 4) + maturity value (PVIF)

= 50(3.1699) + 200(0.68301)
= 158.5 +136.6
= $295.09

Follow up question
A preference share is selling 200 000, 25%, $200, 4 year redeemable share with similar stock
on the market giving a yield of 34% per annum. Calculate the fair price

b) Valuation of Redeemable Preference Shares (with arrear dividends) (Cumulative)

Where preference dividends are in arrears, these have to be brought into account in the
valuation process because the current dividends cannot be paid before the arrear dividends
are cleared. As such an estimation of when the arrear dividend will be paid is needed for
valuation purposes.

Example.
A company in which Z owns 100 000 preference has just made an announcement for financial
difficulties ahead. It is expected that dividends for the next 3 years will not be paid, thereafter
normal dividend payments will then resume. If preference dividends rate is 25% and the
shares are redeemable at the end of 5years.What is the correct value of preference share if

22
required rate of return on similar investments on the market is 20% per year and face value is
$200.

Dividends = 25% of 200

= $50 per share.

Year Cash Maturity Discount Rate@ Present

Dividend Value 20 % Per Year Value
s
1
2
3
4 200 0.48225 96.45
5 50 200 0.40188 100.47
Correct/fair price per share 196.92

c) Valuation of Redeemable –Non Cumulative Preference Shares on arrear dividends

Using the previous example, everything else applies except that the shares are now non-
cumulative in nature. Recalculate the correct price of this share

Year Cash Maturity Discount rate@ Present

dividends value 20 % per year value
4 50 0.48225 24.11
5 50 200 0.40188 100.47
Correct/fair price per share 124.58

d) Valuation of Irredeemable Preference Shares

The correct value of irredeemable preference shares is the present value of the preference
received in perpetuity or forever, thus it is obtained as follows.

Po = Preference dividend per share or Dp

RRR kp

Example.
If an irredeemable preference share has a face value/par value of $45 and a dividend rate of
40%.Similar share on the market are given annual return of 25%.Calculate the correct price.

Po = Pref Div = 18 = $72

kp 0.25

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 Pref dividend = 0.4 x 45 = $18

e) Valuation of Irredeemable Cumulative Preference Share with arrear dividends.

Example 1.
Y Ltd has an issue of 300 000, 30%, $180 cumulative irredeemable preference shares. It has
made an announcement of final challenges ahead. It expects dividends for the next 3 years to
be skipped because of harsh economic environment. Normal dividend payments then resume
with no further skipping. If the required rate of return is 24%, what is the correct value of this
share?
NB: Irredeemable preference shares are valued at the point when normal dividend payments
resume.
Dividend = 0.3 X 180 = $54 per share.

Year Cash Sale Price Discount Rate@ Present

Dividends 24 % Per Year Value
1
2
3
4 216 225 0.42297 186.53

Whereby: Po = Preference Div per share = 54 = $225

kp 0.24

f) Valuation of Irredeemable Non –Cumulative Preference shares with arrear dividends

Using the above example, everything else applies except that the shares are now non-
cumulative in nature, recalculate the correct price of this instrument.

Year Cash Sale Price Discount Rate@ Present

Dividends 24 % Per Year Value
1
2
3
4 54 225 0.42297 118.01

24
==================================================================
3. Valuation of long term debt securities. (Using Investment Analysis BM 204Tables ‘B’)
Long term debt securities such as Loan Notes, Debentures and Bonds (Convertible Loan
Notes) are promises by the borrower (deficiency unit) to pay the principal amount plus period
interest, which is normally paid annually/semi-annually and this has implications in valuation
of such securities. The interest paid is normally stated as a percentage of the face value and
this percentage is known as the coupon rate with the payments being known as the coupon
payments. The frequency of interest payments has a bearing on the valuation of all debt
securities. The correct value of any debt security is thus obtained by adding all present values
of interest to be received and the present value of the maturity value.

NB: If interest is paid semi-annually; we divide the total Interest by 2, the Rate by 2 and
multiply the Periods by 2.

a) Valuation of Redeemable Debt.

These present values are obtained by discounting the future interest payments and maturity
value using the appropriate rate known as the yield to maturity which is equivalent to the
required rate of return. As such, if interests is fixed (annually) the correct value of redeemable
debt security is obtained by the direct formula as follows:

(Use Table ‘A’) (Use Table ‘B’)

Po = Interest (PVIFA r,n ) + Maturity Value (PVIF, r,n)

Whereby: I is the interest receivable in dollar amount per period

RRR is the yield to maturity.

NB: Debt securities can either be Redeemable or Irredeemable and the valuation models do
differ.

Practice question
A Ltd company issues 100 000, 10% per year, 5 year debenture stock. The YTM on similar
debt securities on the market is 8% per year. Calculate the correct value of this debenture if:

25
a) Interest is paid annually
b) Interest is paid semi-annually

a) Po = I (PVIFA r,n ) + maturity value (PVIF, r,n) (Interest Paid Annually)

= $10 000(3.9927) + 100 000 (0.68058)

= $107 985

The paper is selling at a Premium Relative to its fair value. Whenever the coupon rate is
greater than the YTM, it will be sold at a Premium.

CR > YTM = Premium (Interest p.a. + Face value)

NB: Premium is the amount by which a debt security sells over and above its face value and
is obtained by subtracting the face value from the correct price.

Premium = Correct Price – Face Value

Whereby: CR< YTM = it means it will sell at a discount. (Face Value – Interest p.a.)
CR=YTM = it means it will sell at par. (Face Value)

NB: Discount is the amount by which a debt security sells below its face value and this is
always the case when promised Interest Rate (Coupon Rate) is less than the required rate of
return.

Discount = Face Value - Correct Price

b) Interest Paid Semi-Annually.

The interest is going to be divided by 2, the RRR will also be divided by 2 and the 5years
multiplied by 2 therefore:

Po = I (PVIFA r, n x 2) + Maturity Value (PVIF, r, n x 2) (Interest Paid Semi Annually)

2 2
= 10 000 (PVIFA, 8, 5 x 2) + Maturity Value (PVIF, 8, 5 x 2)

26
 2 2 2

= 5000((PVIFA, 4%, 10) + 100 000 (4%, 10)

= 5000 (8.1109) + 100 000 (0.67556)

= $108 110.50

Follow Up Question.
Using the above example, everything else applies except that the coupon rate is now 6% per
annum,
a) Re-Calculate the correct price of this debenture if interest is paid annually and semi-
annually.
b) Suppose the debenture stock was to mature at a premium at 5% of face value, recalculate
the correct price of the debt instrument.
c) Re-Calculate the correct price if YTM is 18% p.a. and is payable annually and semi-
annually.

NB: If a redeemable security is maturing at a discount; one must calculate the discount
amount and deduct it from the par value to get the maturity value. If it’s maturing at
premium, determine the premium and add it to the par to get the maturity value.

b) Valuation Of Irredeemable Debt.

Irredeemable debt pays interest forever. It is normally issued by governments especially
during war times to raise funding to finance the war. For example debt issued in the UK in
1942 is still earning interest. Normally issued by governments because they do not normally
go broke. Such papers are valued as follows:

Po = I = I = I
Kd YTM RRR

NB: kd is the cost of debt/YTM/RRR on similar risk security on the market in decimals

Question.
Suppose a particular parastatal issues a $10 000, 20% per annum irredeemable bond.
Calculate the correct price of this bond if similar papers on the market are giving a yield of

27
a) 14 % p.a. b) 20 % p.a. c) 25 % p.a. I = 2000

a) Po = 2000 = $14 285.71 is selling at a premium, (Coupon Rate > YTM therefore is
attractive)
0.14

b) Po = 2000 = $10 000 is selling at par, (Coupon Rate = YTM).

0.2

c) Po = 2000 = $8 000 is selling at a discount, (Coupon Rate < YTM, therefore not attractive)
0.25

=================================================

Chapter 5 Investment Risks and Return

Any investment decision an investor makes has some uncertainty about it. The uncertainty is
there because no one knows precisely what changes will occur in the investment
environment. Though the terms risk and uncertainty are sometimes used interchangeably,
there is a distinction between them. Uncertainty is about not knowing exactly what would
happen in future regarding our investments whereas risk is how we measure /quantify the
degree of uncertainty in an investment decision thus it can also be defined as the degree of
uncertainty in an investment. In light of the above, the greater the uncertainty in an
investment, the greater the risk of the particular investment and the reverse is true.
Alternatively, risk can also be defined as the chance (Probability) that the return from an
investment decision will not turn out as expected.

Basically there are two major categories of risk that investors are subjected to when they
commit their funds in various investments and these are:

1) Diversifiable risk/Unsystematic risk.

This is the type of risk that can be avoided or eliminated through proper management of risk
ie through diversification. As a result the risk differs from one investor to another as it is
covered by factors peculiar to an individual investor thus the name unique risk or company–
specific risk.
2) Market risk / Unsystematic risk.

28
This risk is covered by adverse changes in market conditions. It is that risk that affects
expected returns of all investments in a particular investment environment in a uniform
manner. The risk is caused by factors common to all investments in a particular
economy/market. There is therefore no insulation / protection by any one investor or firm
from the effects of such risk. As a result, the risk cannot be diversified away in the same
economic environment. Common forms of such risk include:

 Currency/exchange risk
 Purchasing power risk
 Interest rate risk
 Country /political risk

Determination of Expected Return and Risk for Investment

Choosing among alternative investments requires that one estimate and evaluates the risk
return trade-offs for the alternative investments available. As a general rule, the higher the
risk in an investment, the higher the expected rate of return and the reverse is true. However
it should be noted that the risk tolerance levels of investors do differ.

Risk Tolerance

Risk Averse Investors Risk Neutral Investors Risk Loving

Investors

Risk Averse Investors: are those investors that do not like risk and try to avoid it at all costs,
they would rather invest in capital projects / investments offering lower expected returns as
long as they are almost certain / sure that they will recover funds invested. Risk averse
investors prefer sure investments to risky alternatives with identical expected returns. Thus
they view investment with identical expected returns as perfect substitutes or equivalent even
if their risk profiles are different. Their investment decisions are informed by expected returns
alone. However, Risk Loving Investors are more willing to bear risk thus they prefer the
risky investment to the one that is certain because of the possibility of getting a higher rate of
return. As a result, they are optimistic

29
NB: In this module the assumption is that our investor is a risk averse investor aiming to
minimise the risk of his investment decisions.

Choosing Between Individual Investments /Projects.

Example.
Suppose an investor is faced with a choice of which capital project to invest in between two
mutually exclusive investments consequently forecasted data on expected returns for the two
projects for over a 5-year period has been given as follows:

Year Expected Returns Expected Returns

Project A Project B
I 32 33
2 30 30
3 28 29
4 31 30
5 35 31

Required.
a) Based on the expected returns above, which capital project should be chosen for
investment purpose.
b) Determine the risk of project A and B as measured by the range and advise the investors
c) Calculate risk for the two projects above as measured by standard deviation and
recommends the one to take on board.
d) Compute the risk carried by each project as measured by the co-efficient of variation and
advise the investor on which one to invest in.

Measures of Risk.
For the decision maker to make an informed decision there is need to quantify the level of
risk that will be associated with the potential investment being evaluated. There are statistical
approaches that quantify the level of risk associated with a potential investment. These are
now going to be explained and illustrated.

1) Non-Probabilistic Investment Data.

a) Expected Return

30
This is the most likely rate of return to be generated by an investment over a period of time. It
also refers to the future benefits and costs of an investment decision and is obtained as
follows for non-probabilistic data:

n
∑k
k= i=1 i
n

Whereby: k i = Expected Return for each period.

n = Period of investment.

k A = 156% = 31.2% per year.

5

k B = 153% = 30.6% per year.

5

NB: The investor is advised to invest in project A because it has potential to generate a higher
rate of return than project B.

b) Range.
It is a basic measure of risk for investments which is obtained by subtracting the Pessimistic
Return (worst return) from the Optimistic (best expected rate of return).The higher the range,
the greater the fluctuation of Expected Returns for a particular investment and the greater
the risk, however the opposite is true. As result, range is a measure of risk for investment it is
obtained as follows:

Range = Best Expected Return - Worst Expected Return

Range A = (35 - 28) % = 7%

The return for project A has fluctuations of 7%.

Range B = (33 – 29) % = 4%

The return for project B has fluctuations of 4%

NB:

31
The higher the fluctuation, the higher the risk, and low fluctuation means lower risk.

Comment:
Therefore the investor should invest in project B because it has a lower risk as shown by a
lower magnitude of fluctuation of its expected returns. However, range is affected by outliers,
that’s its major weakness.

c) Standard Deviation (dk).

Although the range as explained above can be used to quantify the risk of an asset, it is not
very useful as outliers affect it. A much more useful measure of risk is the standard deviation.
The Standard Deviation (dk) is a measure of the dispersion of returns around the Expected
Value (mean, k) that is it measures the rate of fluctuation of Expected Returns from the most
likely rate of return to be generated by an investment. Expected value of a return (k) is the
most likely return on a given asset. The basic idea is that the Standard Deviation is a measure
of volatility: the more a share’s returns vary from the share’s average return, the more volatile
the share, meaning the higher the standard deviation, the higher the level of fluctuations of
an investment’s returns from the most likely rate of return to be generated and thus the higher
the risk and the opposite is true. It is measured as follows:

n
∑
dk= i=1 (k i - k) 2
n–1

NB: The greater the standard deviation, the greater the risk.

Whereby: k = is the most likely rate of return to be generated by the investment.

k i = is the expected rate of return for each and every year.
n = is the duration of the investment.

dkA =  (32-31.2)2 + (30-31.2)2 + (28-31.2)2 + (31-31.2)2 + (35-31.2)2

4

=  0.64 + 1.44 +10.24 +0.04 +14.44 = 2.59%

4
NB:
The returns for project A fluctuate below or above the most likely expected return by 2.59 %.

32
=================================================================

dkB =  (33-30.6) + (30 -30.6)

2 2
+ (29 +30.6)2 + (30-30.6)2 + (31-30.6)2
4

=  5.76 + 0.36 +2.56 +0.36 +0.16

4

= 1.52%

NB:
The returns for project B fluctuate below or above the most likely expected return of 30.6 by
1.52%

Comment:
Therefore the investor is advised to invest in project B because it has a lower risk as shown
by a lower magnitude of fluctuation (1.52%) of its expected returns from the most likely rate
of return to be generated by the investment.

d) Coefficient of variation (C.V).

This is the best measure of risk for investments as it measures risk carried by each unit of
Expected Return. This makes it a relative risk measure which can be used to compare
investments that are different in scale or size. It can also be used to compare investments that
have different expected rate of returns. The higher the coefficient of variation, the higher the
risk carried by each unit of expected return for a particular investment and the opposite is
true.

It is calculated as follows:

CV = standard deviation (dk) x 100

Expected return (k)

CV A =2.59 % x 100 = 8.30% per unit

31.2 %
==================================================================

CV B = 1.52% x 100 = 4.97% per unit

30.6%
33
Comment:
Therefore the investor should invest in project B since it has a lower risk per each unit
(4.97%) of expected return.

2) Probabilistic investment data

Sometimes the rates of returns for investments are assigned economic scenarios and
probabilities of these scenarios happening as shown below:

The following data is given for two investments under different economic situations as well
as their probabilities of occurrence.

Economic Scenario Probability(Pr) X (%) Y (%)

Low inflation 0.2 24 18
Moderated inflation 0.5 20 22
High inflation 0.3 16 24

Required.
a) Determine the Expected Rate of Returns for projects X and Y.
b) Calculate risk for the two projects as measured by Standard Deviation and recommend.
c) What is the risk carried by each unit of expected returns for projects X and Y?

a) Expected Returns Computation.

For a Probabilistic Distribution, the expected value is the weighted value of possible return
multiplied by the probability of occurrence. It is obtained by using the following formula:

n
∑
k= i=1 (ki = Pri)

Whereby: ki = Expected Return under different economic situations

Pri = Probability of occurrence of each outcome.
kx = (0.2 x 24%) + (0.5 x 20%) + (0.3 x 16%)
= 4.8% +10% +4.8%
= 19.6 %
==================================================================
ky = (0.2 x18%) + (0.5 x 22%) + (0.3 x 24 %)
= 3.6% +11% +7.2%

34
 = 21.8%

Comment:
Therefore the investor is recommended to take investment Y because it has potential to
generate a higher rate of return of 21.8%

b) Standard deviation computation.

To get the standard deviation of a probabilistic distribution use the following formula:

n
∑
dk =  i=1 (ki - k) 2 x Pri

dk x =  0.2(24 - 19.6)2 + 0.5 (20 - 19.6)2 + 0.3(16 - 19.6)2

=  0.2(19.36) + 0.5(0.16) +0.3(12.96)

= 2.8 %

==================================================================

dk y =  0.2(18 – 21.8)2 + 0.5 (22 - 21.8)2 + 0.3(24 – 21.8)2

=  0.2(14.44) + 0.5(0.04) +0.3(4.84)

= 2.1%
Comment:
Therefore investment y is recommended because it has a lower risk as shown by the lower
magnitude of fluctuation of its expected returns from the most likely rate of return.

c) Co-efficient of variation.

C.V x 2.8 x 100 =14.3%

19.6
==================================================================

C.V y = 2.1 x 100 = 9.6%

35
 21.8

Comment:
Therefore investment y is recommended because it has a lower risk as shown by the lower
magnitude of fluctuation of its expected returns from the most likely rate of return

Follow Up Question
A to Z company has provided you with the following information:
State Of Probabilit Return On Return On
Economy y Project X (%) Project Y (%)
Bumper harvest 0.2 34 30
Good harvest 0.4 28 28
Moderate harvest 0.3 22 26
Low harvest 0.1 18 20

a) On the basis of Expected Returns Alone, which project should be taken on board and why
(6 marks)
b) Explain why Range is not the best tool to use as a measure of risk (3 marks)
c) Compute the risk of these projects as determined by Standard Deviation and recommend
the one to invest in (7 marks)
d) Write brief notes on coefficient of variation as a measure of investment risk (4 marks)
e) Calculate the Coefficient of Variation of the two investments and comment on which
project to invest in (5 marks)

End of module
Good Luck

36