12/18/19

L/O/G/O

SECURITIES ANALYSIS
AND INVESTMENT

OUTCOMES
v Analyse investment environment
v Understand and apply methods to analyse and value bonds
v Understand and apply methods to analyse and value shares
v Understand content and know how to build the optimal
investment porfolio

Assessment
v  Attendance: 10%

v  Assignment: 15%

v  Semi exam: 15%

v Final exam: 60%

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Materials
•  Investment -10th Edition- Bodie, Kane, Macus –
Mc Graw-Hill.
•  Investment Analysis and portfolio management,
7th edition, Frank Reilly and Keith Brown.
•  Giáo trình Phân tích và Đầu tư chứng khoán,
2018, Học viện Ngân hàng

www.themegallery.com

Assignment
•  You want to invest amount of money in securities
market. You could choose to invest in listed
stocks in Ho Chi Minh stock exchange or Hanoi
stock exchange.
•  You need to analyse macro economy, industry,
and companies to choose some stocks to invest.
Then, you need to build an portfolio based on
your risk appetite.
•  Deadline for submission: week 7.

Assignment requirements
•  Maximum 7 students/group
•  15 minute to present and answer questions
•  Submit reports

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Contents

1 INVESTMENT ENVIRONMENT

2 BONDS ANALYSIS AND VALUATION

3 STOCKS ANALYSIS AND VALUATION

4 INVESTMENT PORTFOLIO BUILDING

L/O/G/O

CHAPTER 1:
INVESTMENT ENVIRONMENT

CONTENTS

1
SECURITIES INVESTMENT

2
RISK AND RETURN

3
INVESTMENT PROCESS

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1. SECURITIES INVESTMENT

REAL ASSETS AND FINANCIAL ASSETS

11

Concept check
What are financial asset?
1.  Patent
2.  Certificates of deposit
3.  Future contract
4.  Bonds

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INSTRUMENTS
v  Securities are the proof confirming the legitimate rights
(claims) of the ownership of holders on the property or capital of
the issuer.
Confirm the legal rights of securities holders, including :
Ownership ( for equity securities)
Debt owner’s rights (debt securities: corporate bonds, sovereign
bonds)
Financial rights related to securities ( for derivatives)
v  Securities are in the form of paper certificates, a book entry or
electronic data.
v  Protected by securities laws

Financial investment

Financial investment is a type of investment that

investors buy financial instruments to earn periodic
income or take profit from capital gain.

Financial Investment

Features of financial investment:

–  Return
–  Risk
–  Liquidity

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Financial Instruments

Fixed income assets Stocks Derivatives

•  Fixed income for •  Signify an •  A security whose

holders: bonds ownership position price is dependent
•  Monetary market in a corporation, on one or more
instruments: and represents a underlying assets
treasury bills, claim on its •  Forwards, futures,
certificates of proportional share options
deposit, in the corporation’s
commercial bills assets and profits
•  Capital market •  Uncertain income
instruments: bonds,
treasury bonds,
municipal bonds,
corporate bonds.

FINANCIAL INSTRUMENTS

Treasury inflation – Protected Securities (TIPS) :

Treasury bonds backed by the faith and credit of the
Treasury that provide a promised yield in real terms-
that is, the principal and interest payments are
indexed to the Consumer Price Index (CPI).
- Principal value is adjusted to reflect the inflation

FINANCIAL INSTRUMENTS

Treasury inflation – Protected Securities

Example: TIPS: Face value: $1000
Coupon rate: 4%/year
Payment period: half year
Determine coupon interest investor receive if CPI in the
first 6 moths from issuing date is 1%?

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TIPS

FV after being adjusted to reflect inflation:

F = 1000 + 1000*1% = $ 1010
Coupon interest:
C = 1010 * 2% = $20.2

INVESTING IN SECURITIES MARKET

•  Orders:
–  Limited order (LO)
–  Market price (MP)
–  ATO
–  ATC
–  Stop order

INVESTING IN SECURITIES MARKET

•  Special transactions:
–  Margin trading
–  Short selling

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II. RISK AND RETURN

MEASURE OF RETURN

Measure of return: determine change in wealth

resulting from an investment.
Change in wealth due to:
•  Cash inflows: interest, dividends
•  Change in price of assets (positive or negative)

Measure of return

Example: An investor sell 1000 shares of

GAS at the price $60 today. 1 year before, he
bought these shares at $45 and GAS tend to
pay dividend at 20% / share next year.
Determine return of this investment?
Return = Dividend + capital gain/loss

= (0+ 15) x 1000 = $15000

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Measure of return
•  Holding Period Return – HPR

Measure of return
•  Holding Period Yield – HPY
HPY = HPR annual - 1

HPR annual = HPR1/n

n: investment period (number of year)

Measure of return
•  Example: An investment in a stock at price
$1000. After 2 years, the investment value
increase to $1100 and received dividend is
$40. Determine HPR, HPY?
HPR = 1140/1000 = 1.14
HPR annual = 1.141/2 = 1.068
HPY = 1.068 – 1 = 6.8%

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Measure of return
Mean rates of return: over a number of years, a single
investment will likely give high rates of return during
some years and low rates or possibly negative rates of
return.
Arithmetic mean (AM):
AM = (HPY1+HPY2+…+HPYn)/n
Geometric mean (GM):
GM = [(1+HPY1)(1+HPY2)…(1+HPYn)]1/n – 1

Measure of return
•  Example:
Year Beginning Ending HPY
value value
1 100 120 0.2
2 113 140 0.239
3 110 104 - 0.054

Determine mean rates of return (arithmetic

mean and geometric mean)?

Mean rates of return

–  Arithmetic mean
AM = (0.2 + 0.239 - 0.054)/3 = 12.8%

–  Geometric mean
GM = [(1+0.2)(1+0.239)…(1-0.054)]1/3 - 1= 12.04%

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Measure of return
Expected Rates of Return: determine rates of return of an
investment in the future based on range of possible returns. An
investor determines how certain the expected return on an
investment is by analyzing estimates of possible return and
probability of return.
n
E(Ri ) = ∑P *R i i
i=1

Pi: Probability of return

Ri: Possible return

Measure of return
•  Example: An investment in stock XYZ has
potential returns as the following:
HPY Probability
0.8 20%
0.1 40%
-0.35 40%

Determine the expected return?

Measure of risk

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Risk

Risk
The
uncertainty
of
Systematic Unsystematic
achieving
risk risk
the
expected
return

RISK

Risk = UNCERTAINTY
Risk = the variation of return associated with a given asset
Risk = the deviation of realized rate of return from expected
rate of return.

MEASURE OF RISK
•  Consider 2 investment assets:

A B

Possible return 4% 6% -8% 2% 6% 20%

Probability of 50% 50% 25% 25% 25% 25%

occurrence

Expected 5% 5%
return

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MEASURE OF RISK
•  Variance: measure the dispersion of possible
rates of return around the expected rate of
return.

Pi : probability
Ri : possible return
E( R ) : expected return

Measure of risk
•  Consider 2 investment asset
A B
Possible return 4% 6% -8% 2% 6% 20%
Probability of 50% 50% 25% 25% 25% 25%
occurrence
Expected 5% 5%
return

Variance:
A: σ2 = 0.5 (0.04-0.05)2 + 0.5(0.06-0.05)2 = 0.0001 (0.01%)
B: σ2 = 0.25(-0.08-0.05)2 + 0.25(0.02-0.05)2 + 0.25(0.06-0.05)2 +
0.25(0.20-0.05)2 = 0.0101 (1.01%)

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Measure of risk
Standard Deviation: is the square root of the
variance

Pi : probability
Ri : possible return
E( R ) : expected return

Exercise
An investor invest 270 million dong in stocks XYZ at price
90000 dong/share. In next year, the investor could receive
cash dividend at rate 30% and the stock price is predicted
to be as following:
XYZ price 1 year later Probability
85.000 0.2
91.500 0.5
98.500 0.3

Determine the expected return and risk?

Exercise

Stock pi (2) Ri HPY Ri – pi * [Ri –

price (3) = [(1)- (4) = (3)*(2) E(R) E(R)]^2
(1) P0+DIV]/P0
85.000 0.2 - 2.2 % - 0.44 (%) - 8.1 13.122
91.500 0.5 5% 2.5 (%) -0.9 0.405
98.500 0.3 12.8 % 3.84 (%) 6.9 14.283
Total E(R) = 5.9 % σ2 = 0.2781
(%)

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Exercise 2:
•  Stock A and B has possible returns as following:

Probability Pi RAi RBi

#1 0.3 80% 15%

#2 0.4 10% 10%
#3 0.3 -60% 5%

•  Determine return and risk of stock A and B ?

Stock A
Probability Pi Ri Pi×Ri Ri - E(R) (Ri - E(R))^2 Pi×(Ri - E(R))^2

#1 0.3 0.8 0.24 0.7 0.49 0.147

#2 0.4 0.1 0.04 0 0 0

#3 0.3 -0.6 -0.18 -0.7 0.49 0.147

Sum E(R) =0.1 σ2 = 0.294

σ = 0.2941/2 = 54.22%

Stock B
Probability Pi Ri Pi×Ri Ri - E(R) (Ri - E(R))^2 Pi×(Ri - E(R))^2

#1 0.3 0.05 0.015 -0.05 0.0025 0.00075

#2 0.4 0.1 0.04 0 0 0

#3 0.3 0.15 0.045 0.05 0.0025 0.00075

Sum E(R) =0.1 σ2 = 0.0015

σ = 0.00151/2 = 3.87%

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Coefficient of variation (CV)

Coefficient of variation is a measure of relative variability to
indicate risk per unit of expected return.

This measure of relative variability and risk is used by financial

analysts to compare alternative investments with widely different
rates of return and standard deviations of returns.

Example
Consider 2 investment asset

A B
Possible return 4% 6% -8% 2% 6% 20%
Probability of 50% 50% 25% 25% 25% 25%
occurrence
Expected 5% 5%
return

Determine risk?
A: σ2 = 0.5 (0.04-0.05)2 + 0.5(0.06-0.05)2 = 0.0001 (0.01%)
B: σ2 = 0.25(-0.08-0.05)2 + 0.25(0.02-0.05)2 + 0.25(0.06-0.05)2 +
0.25(0.20-0.05)2 = 0.0101 (1.01%)

CV (A) = √0.0001/0.05 = 0.2

CV (B) = √0.0101/0.05 = 2

Exercise
•  Consider the following 2 investments:

A B
Expected return 0.07 0.12

Standard deviation 0.05 0.07

•  Which investment is more attractive?

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Risk measure for historical returns

It indicate how much the individual HPYs over time deviated from
the expected value of the series.
•  Variance

•  Standard deviation

Financial asset return and risk

INVESTMENT PROCESS

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INVESTMENT PROCESS

1.  Determine investment policy

2.  Analyze securities
3.  Portfolio construction
4.  Portfolio management

Discuss

Based on private finance plan,

determine investment plan?

Determine investment policy

•  The policy statement is a road map. Investors

specify the types of risks they are willing to
take and their investment goals.

•  The policy statement must be periodically

reviewed and updated.

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Investment policy
•  Investors need to evaluate their risk tolerance via doing
survey from investment firms.
•  Risk tolerance is affected by individual’s psychological,
family situation, cash reserves, current net worth, income
expectations and age.

For ex: Individual with higher incomes have a greater

propensity to undertake risk because their incomes can help
cover any shortfall.

Example
What is an appropriate investment objective for our typical
25-year-old investor?
Assume he holds a steady job, is a valued employee, has
adequate insurance coverage, and has enough money in the bank
to provide a cash reserve. Let’s also assume that his current long-
term, high-priority investment goal is to build a retirement fund.
Depending on his risk preferences, he can select a strategy
carrying moderate to high amounts of risk because the income
stream from his job will probably grow over time.
Further, given his young age and income growth potential, a low-
risk strategy, such as capital preservation or current income, is
inappropriate for his retirement fund goal; a total return or capital
appreciation objective would be most appropriate.

Example
Investment Objective: 65-Year-Old
Assume our typical 65-year-old investor likewise has adequate insurance
coverage and a cash reserve. Let’s also assume she is retiring this year.
This individual will want less risk exposure than the 25-year-old investor
because her earning power from employment will soon be ending; she
will not be able to recover any investment losses by saving more out of
her paycheck.
Depending on her income from social security and a pension plan, she
may need some current income from her retirement portfolio to meet
living expenses.
Given that she can be expected to live an average of another 20 years,
she will need protection against inflation.
Invest in stock and bond investments to meet income needs (from bond
income and stock dividends) and to provide for real growth (from
equities). Fixed-income securities should comprise 55–65 percent of the
total portfolio

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Example

Determine investment policy

•  Investment goals
Ø Return
Ø Risk
•  Investment constraints
Ø Liquidity limitation
Ø Time horizon
Ø Tax and legal framework
Ø Others

Investment constraints
•  Liquidity: Investors may have liquidity needs that the
investment plan must consider. Although an investor may
have a primary long-term goal, several near-term goals
may require available funds.

Example: Our soon-to-be-retired 65-year-old investor has a

greater need for liquidity. She will want some of her portfolio
in liquid securities to meet unexpected expenses, bills, or
special needs such as trips or cruises

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Investment constraints
•  Time horizon: Investors with long investment horizons
generally require less liquidity and can tolerate greater
portfolio risk: less liquidity because the funds are not
usually needed for many years; greater risk tolerance
because any shortfalls or losses can be overcome by
earnings and returns in subsequent years.

Example: Because of life expectancies, our 25-year-old

investor has a longer investment time horizon than our 65-
year-old investor.

Securities analysis
•  Analysis methods
Ø Fundamental analysis
Ø Technical analysis

•  Aims
Ø Choose securities, determine price and time to
buy and sell.

Portfolio construction
•  Portfolio is constructed based on diversification rule
that could minimize the investors’ risks while meeting
the needs specified in the policy statement.

•  With the investor’s policy statement and securities

analysis, investor implement investment strategy and
determine how to allocate available funds across
countries, asset classes, and securities.

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Portfolio management
•  Portfolio management process is the continual monitoring of
the investor’s needs and capital market conditions and when
necessary, updating the policy statement.
•  An important component of the monitoring process is to
evaluate a portfolio’s performance and compare the relative
results to the expectations and the requirements listed in the
policy statement.

•  Active portfolio management

•  Passive portfolio management

L/O/G/O

w w w . t h e m e g a l l e r y . c o m

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CHAPTER II:
BOND ANALYSIS AND
VALUATION

CONTENTS

BASIC FEATURES

RISK OF BOND INVESTMENT

BOND PRICING

BOND YIELDS

DURATION

CONVEXITY

Bonds

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Characteristics
1. Par Value
–  Nominal value of bonds, printed on the bonds’ faces
–  Uses of par value?
2. Maturity
- The period of time from when the bond is issue to when the loan
is due
- Determined when the bond is issued
- Varies in maturities: Short-term bonds (1 – 5 years), Mid-term
bonds (5 – 12 years), Long-term bonds (over 12 years)
- Bond yields & price fluctuation are related to maturities (Yield to
Maturity – YTM)

Yield Curve

Characteristics (cont.)
3. Coupon rate (nominal rate)
-The amount of interest committed by the bond issuers to pay for the
bond holders, calculated as a percentage of the par value.
-Determined at the time of issuance along with the bond’s maturity,
can be fixed or gradually increasing (step-up notes)
-The CR are used for auctioning when issuing bonds
4. Issuing price
-The price at which the bond is sold out at issuance
-Can be larger, smaller than, or equal to the par value
5. Interest payment period
-The frequency of interest payments
-Can be annual, semi-annual, quarterly or none (Zero coupon bonds)

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1. Basic features

Bond is an obligation that issuer (the borrowers) must

repay to the owners of the bond (the lender) the
principal amount at maturity and a certain amount of
money (interest) in a certain period of time.
Returns:
–  Coupon : annual or semi- annual
C = C(%) * F
–  Capital gain or loss

–  Return on reinvesting of interest

Rate of return on Bonds

•  Holding period return (HPR)

•  Holding period yield (HPY)

1. Features

•  Some special features:

-Callable bonds: allow the issuer to retire the bond at determined
period.
-Putable bonds: investors could sell bonds back to the issuer at a
determined price. This option increase in value when interest rate
increase
-Convertible bonds: have the interest and principal characteristics
of other bonds with the added feature that the bondholder has the
option to turn them back to the firm in exchange for its common
stock.
- Floating rate bonds: the coupon rate is not fixed, it is adjusted
periodically based on the market interest rate. It is determined by a
benchmark.

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Convertible bonds

Convertible Bonds are bonds could be converted

to common stocks at determined price, called
conversion price.
–  P: Conversion price
F
–  F: Face value
P =
–  Cr: conversion rate cr

Convertible bonds

Example: A convertible bond of SSI has face

value 1 million dong. It could be converted to
common stocks of SSI at conversion price
100000 dong.
Determine conversion rate?

Risk of bond investment

•  Credit rating risk

•  Interest rate risk
•  Liquidity risk
•  Inflation risk

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Credit rating

An assessment of the credit worthiness of a borrower in

general terms or with respect to a particular debt or financial
obligation

Can be assigned to any entity that seeks to borrow

money – an individual, corporation, state or provincial
authority, or sovereign government
Generally done by a credit rating agency (Moody’s,
S&P, Fitch)

Credit rating
Rating system:
–  High rate = low credit risk
–  Denoted by symbol
Moody’s: Aaa
S&P: AAA
Fitch: AAA
–  Investment grade bond & high – yield bond
–  Rating transition matrix
Factors considered in assigning rating (Cs)
–  Character of management
–  Capacity of issuer
–  Collateral
–  Covenants 14

Credit rating

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Interest rate risk

Price fluctuation risk Reinvestment risk

•  When market Interest
rate increase, bonds
price decrease
•  When market Interest
rate increase, bonds
price decrease
•  When market interest
rate fluctuate, returns
on coupon
reinvestment could be
affected

Liquidity risk

Liquidity describes the degree

to which an asset or security
can be quickly bought or sold
in the market without affecting
the assets price
Liquidity risk depends on the
development of the secondary
market

Inflation risk

•  Inflation decrease the value of money, then has

impact on expected return of bonds. Coupon
bonds paying fixed interest have higher
inflation risk.
Nominal rate = Real rate + inflation
•  Inflation increase, bonds price decrease

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Exchange rate risk

•  When investors use domestic currency to

invest in bonds that is denominated in foreign
currency
•  Exchange rate risk occurs when exchange rates
are different at the beginning investment
period and ending investment time.

3. BOND VALUATION

•  Rules:
v  Determine the present value of bond’s expected
cash flows in the future at appropriate discount
factor (required rate of return on the bond)

3. BOND VALUATION

Cash flows from a bond:

-  Periodic interest payments to the bond holder
C = C(%)*F

-  Repayment of principal at maturity

⇒ The value of bond is the present value of
interest payments plus the present value of the
principal payment

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BOND VALUATION

$C $C $C $C+F
……
0 1 2 3 . T

…….

P: Current market price

T: Number of years to maturity
C: Coupon payment
r: Required rate of return
F: Face value

BOND VALUATION

Bond valuation steps:

1.Determine expected cash flows from bonds in the
future.
-Interest payment (annual, semi- annual)
-Principal value (at maturity)
2. Determine discount rate r
-It is required rate of return on the bond
-It could be determined via similar bonds in the market
3. Bond pricing formula or using excel file

BOND VALUATION

Example 1: Company A issue bonds:

-  Face Value: 1 million dong
-  Coupon rate: 12%
-  Paying interest annually
-  Maturity = 3 year
-  Required interest rate: 10%
Determine bond price?

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BOND VALUATION

Example 2: Company A issue corporate bond

-  Face value: 1 million dong
-  Maturity: 15 year
-  Paying interest semi-annually
-  Coupon rate: 15%
-  Required rate of return: 10%
Determine bond price?

BOND VALUATION

•  Paying interest annually

⎡ 1− (1+ r)− n ⎤ −n
P =C⎢ ⎥ + F(1+ r)
⎣ r ⎦
•  Paying interest semi-annually
⎡ 1− (1+ r / 2)−2n ⎤
P =C⎢ ⎥ + F(1+ r / 2)−2n
⎣ r /2 ⎦

BOND VALUATION

Zero- coupon bonds

Example: Consider a bond as following:
-  Maturity: 20 years
-  No periodic interest payment
-  Face value: 1 million dong
-  Market rate of return: 10%
How much does investor pay to buy this bond?

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ZERO COUPON BOND VALUATION

•  Zero- coupon bonds:

–  No periodic interest payment
–  Only one cash flow is principal value at maturity

F
P=
(1+ r)T

EXERCISE

•  Exercise 1: Determine bond price

-  Face value: $1000
-  Coupon rate: 10%
-  Required rate of return: 12%
-  Maturity: 20 years
-  Paying interest semi- annually
2. What happen to bond price if required rate of
return is only (i) 7; (ii) 10%

BOND VALUATION

•  Exercise 2: A treasury bond has maturity 20

years. It was issued 10 year ago. Face value is
1 million dong, coupon rate is 10%. This bond
pay interest annually. Required rate of return is
8%.
Determine current bond price?
•  Exercise 3: Determine price of above bond at
issuing time.

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BOND VALUATION BETWEEN COUPON PAYMENTS

Accrued Interest: when an investor purchases a bond between

coupon payments, the investor must compensate the seller of the
bond for the coupon interest earned from the time of the last
coupon payment to the settlement date of the bond.
Dirty Price = Clean Price + Accrued Interest
Accrued interest = C x (the time of the last coupon payment to
the settlement date/ coupon payment period)
- The price of a bond without accrued interest is called the clean
price. It usually be quoted in the market. When quoting bond
price, traders quote the price as a percentage of par value.
- Accrued interest is based on the actual number of days the bond
is held by the seller

BOND VALUATION BETWEEN COUPON PAYMENTS

Exercise:
Bond A has face value $1000. Coupon rate 9%, paying
interest annually. Bond A is quoted at the price 108%
face value. The last coupon had been paid last month.
Determine bond price?

EXERCISE

•  You want to buy a corporate bond with FV

$1000, coupon rate 8%. Listed price is $1002.5
•  This bond pays interest semi- annually on 15/2
and 15/8. How much do you need to pay for
this bond?

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RELATIONSHIP BETWEEN BOND PRICE

AND YIELD

Bond A has 10 years to maturity, coupon rate

10%/year, FV = $1000. Bond A pay interest
annually. Rate of return received when investing
in other similar bonds is 12%. Determine bond
price?

Bond pricing

•  r = 12%, F = 1000$
•  C = 1000 * 10% = 100$
• 

Bond pricing

•  Case 1: r = 12%/năm
•  Case 2: r = 10%/năm
•  Case 3: r = 8%/năm

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RELATIONSHIP BETWEEN BOND PRICE

AND YIELD

Rate of Bond price (P) Features

return ( r )
12% 887.00$ The bond will be priced at a
discount to its par value
10% 1000.00$ Par value Bond

8% 1134.00$ The bond will be priced at a

premium above its par value

RELATIONSHIP BETWEEN BOND PRICE AND

YIELD

Bond price moves inverse to yield

38

RELATIONSHIP BETWEEN BOND PRICE AND

YIELD

Price

YIELD (%)

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RELATIONSHIP BETWEEN BOND PRICE AND

YIELD

1134

1000

887

8 10 12

4. COMPUTING BOND YIELDS

Yield measure Purpose

Nominal yield Measures the coupon rate

Current yield Measures the current income rate

Promised yield to maturity Measures the estimated rate of return for

bond held to maturity

Promised yield to call Measures the estimated rate of return for

bond held to first call date

Realized (horizon) yield Measure the actual rate of return on a bond

during holding period.

NOMINAL YIELD

•  Nominal yield relates the coupon interest to the face

value. Nominal yield is the coupon rate.
•  Formula:

Periodic Coupon Interest

Nominal yield = (%)
Face value

42

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Current Yield

•  Current yield measures the current income from the

bond as a percentage of its price.
•  It is important to income- oriented investors who
want current cash flow from their investment
portfolios.
•  It excludes the important capital gain or loss
component
Periodic Coupon Interest
Current yield = (%)
Current market price

Current yield

•  Example
A bond has 5 years to maturity. Coupon rate is
8%/ year, face value is $100. This bond pays
interest annually. The current market price is
$94. Determine current yield?

Internal rate of return (IRR)

•  Internal rate of return is the interest rate that will make
the present value of the cash flows from the investment
equal to the price (or cost) of the investment.
Mathematically, the IRR is the interest rate that satisfies
the equation.

Ø r : IRR
Ø P1: ending investment period price

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Internal rate of return

Solving for the IRR requires a trial- error (iterative)
procedure. The objective is to find the interest rate
that will make the present value of the cash flows
equal to the price
•  Step 1: Determine NPV based on price formula
•  Step 2: Choose r1 for NPV1>0
r2 for NPV2 < 0
(with r1< r2)
•  Step 3: Apply formula:
NPV1 (r2 − r1 )
IRR = r1 +
46 NPV1 + NPV 2

Yield to maturity

•  Yield to maturirty is the interest rate that will make the

present value of the cash flows equal to the price. The
cash flows are those that the investor would realize by
holding the bond to maturity.
•  Yield to maturity is the most widely used bond yield
figure because it indicates the fully compounded rate of
return promised to an investor who buys bonds and
holds to maturity. YTM bases on 2 assumptions:
-  Investor hold the bond to maturity
-  Investor reinvest all the coupon interest at the YTM
47

Yield to Maturity

The yield to maturity is computed in the same

way as the internal rate of return (IRR)

F : Face value

16
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Yield to Maturity

Example: A bond has face value 1 million dong,

2 years to maturity. Coupon rate 10%. The
market price is 1035000 dong. If investor hold
this bond to maturity, what is rate of return?

Yield to Maturity

•  r1 : interest rate makes f1 > 0

•  r2 : interest rate makes f2 < 0

Yield to Maturity

Exercise
A bond has 5 years to maturity, coupon rate 8%,
face value $100. This bond pays interest
annually. The current market price is $94.
Determine YTM?

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Yield to call

•  Yield to call is the interest rate that investor could receive

if this bond is called before maturity

C : coupon payment
y : yield to call
M: Call price (the price at which the bond may be called)

Yield to call

Price

Non-callable bonds

Callable
bonds

Yield

Yield to call

•  Exercise: Company XYZ wanted to raise fund immediately

for a project. They decided to issue 1000 bonds with maturity
10 years. Coupon rate 10%/year, paying interest semi-
annually. The coupon rate was higher than the credit rating of
this company. So they added callable feature to these bonds.
They could buy bond back 5 years after issuing. The call price
is higher than face value 10%. Now, after 3 years from issuing,
the market price of this bond is $1050.
a.  If an investor buy these bonds now, and hold to maturity, is
the rate of return equal to the nominal rate?
b.  If this company call these bond, determine yield to maturity.
Is it good for investors?

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Yield to maturity and default risk

Example: A company issue bonds with coupon rate 9%

20 years ago, face value $1000. These bonds has 10 years
to maturity but this company meet financial trouble and
could not pay all principal. They just pay 70% face value
of these bond at maturity. This bond is sold at $750.
⇒ Promised YTM = 13,7%
⇒  Real YTM = 11,6%

55

Realized Return

•  Realized return is the actual return over investment

period when reinvestment rate change overtime.
•  Formula:

Realized yield

The steps to calculate an expected realized yield can be summarized as

follows:
- Calculate the future value at the horizon date of all coupon payments
reinvested at estimated rates.
-Calculate the expected sales price of the bond at your expected horizon
date based on your estimate of the required yield to maturity at the horizon
date.
-Sum the values in Steps 1 and 2 to arrive at the total ending-wealth value.
-Calculate the ratio of the ending-wealth value to the beginning value (the
purchase price of the bond). Given this ratio and the time horizon,
compute the compound rate of interest that will grow to this ratio over this
time horizon.
- If all calculations assume semiannual compounding, double the interest
rate derived from Step 4.

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Realized Return

•  Example
A bond has 3 years to maturity, coupon rate
10%/year, face value 100$. Yield to maturity is
10%. This bond pay interest annually. Determine
realized yield investors receive when investing in
these bonds. Given that reinvestment rate for
coupon is 8%/ year

Relationship among yields

When a bond is priced at discount:

YTM > current yield > nominal yield
When a bond is priced at par:
YTM= current yield = nominal yield
When a bond is priced at premium:
YTM < current yield < nominal yield

BOND PRICE OVERTIME

BOND PRICE MOVES TO PRINCIPAL WHEN BONDS
COME TO MATURITY

Time to Maturity Premium Bond Par Value Bond Discount Bond

10 1134.20$
1134.20 1000.00$
1000.00 887.00
887.00
9 1124.93 1000.00 893.43
8 1115.00
1115.00$ 1000.00
1000.00 901.00
901.00
7 1104.12 1000.00 908.72
6 1092.50 1000.00 917.77
5 1079.85 1000.00 927.90
4 1066.24 1000.00 939.25
3 1051.54
1051.54 1000.00
1000.00 952.00
952.00
2 1035.66 1000.00 966.19
1 1018.50 1000.00 982.14
0 1000.00
1000.00 1000.00
1000.00 1000.00
1000.00

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BOND PRICE OVERTIME

1134

1000

887

INTEREST RATE RISK

CONTENTS:

•  Interest rate in bond investment

•  Duration

•  Convexity

What determines the price volatility for

bonds? (Malkiel- 1962)
There is inverse relationship between changes in yields and the price of
bonds.
There are specific factors that affect the amount of price change for a
yield change in different bonds.
Bond price volatility is measured as the percentage change in the price
of the bond

EPB = the ending price of the bond

BPB = the beginning price of the bond
A bond with high price volatility or high interest rate sensitivity is one
that experiences a relatively large percentage price change for a
given change in yields.

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What determines the price volatility for

bonds? (Malkiel- 1962)

Malkiel (1962) used the bond valuation model to demonstrate that the
market price of a bond is a function of four factors: (1) its par value,
(2) its coupon, (3) the number of years to its maturity, and (4) the
prevailing market interest rate.
Malkiel’s mathematical proofs showed the following relation- ships
between yield (interest rate) changes and bond price behavior:
1.Bond prices move inversely to bond yields (interest rate)
2.Bond price movements resulting from equal absolute increases or
decreases in yield are not symmetrical. A decrease in yield raises
bond prices by more than an increase in yield of the same amount
lowers prices

What determines the price volatility for

bonds? (Malkiel- 1962)

3. For a given change in yields, longer maturity bonds

experience larger price changes; thus, bond price volatility
is directly related to term to maturity.
4. Bond price volatility increases at a diminishing rate as
term to maturity increases.
5. Higher coupon issues show smaller percentage price
fluctuation for a given change in yield; thus, bond price
volatility is inversely related to coupon.
6. Bond price volatility increase when bonds are sold at the
lower yield to maturity

Relationship 1 and 2

Price

P1

P2

Y1 Y Y2 Yield

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Relationship 1 and 2

•  Example: A bond has face value $100, pays interest

semi-annually, coupon rate 6%/ year. This bond has 5
years to maturity. Yield to maturity is 6%/year.
Determine percentage change in bond price when
YTM is 4%, 5%, 7%, 8%?

Relationship 1 and 2

Bond price (6% coupon rat, maturity 5 years)

YTM 8% 7% 6% 5% 4%

PV of 24.3 24.9 25.6 26.3 26.9

interest

PV of 67.6 70.9 74.4 78.1 82.0

principal

Bond price 91.9 95.8 100 104.4 108.9

% bond -8.1 -4.2 4.4 8.9

price change

Relationship 3 and 4
3. For a given change in yields, longer maturity bonds experience
larger price changes; thus, bond price volatility is directly related to
term to maturity.
4. Bond price volatility increases at a diminishing rate as term to
maturity increases.
Example: 3 bonds have similar face value $100 and coupon rate 6%/
year, pay interest semi-annually. These bonds are sold at YTM 6%/
year.
-  Bond A maturity: 1 year
-  Bond B maturity: 5 year
-  Bond C maturity: 20 year
Determine percentage change in price of each bond when YTM change
from 6% to 8%.

23
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Relationship 3 and 4

Bond price ( 6% coupon rate)

Maturity 1 year 5 year 20 year
YTM 6% 8% 6% 8% 6% 8%
PV of 5.7 5.6 25.6 24.3 69.3 59.4
interest
PV of 94.3 92.5 74.4 67.6 30.7 20.8
principal
Bond 100 98.1 100 91.9 100 80.2
price
% price -1.9 -8.1 -19.8
change

Relationship 5

5. Higher coupon issues show smaller percentage price

fluctuation for a given change in yield; thus, bond price volatility
is inversely related to coupon.
Example: 3 bonds have face value $100, maturity 20 years, yield
to maturity 6%.
-  Bond A is a zero coupon bond
-  Bond B is a coupon bond at rate 6%
-  Bond C is a coupon bond at rate 9%
Determine percentage change in price of each bond when YTM
change from 6% to 8%.

Relationship 5

Bond price (maturity: 20 years)

Coupon 0% 6% 9%
YTM 6% 8% 6% 8% 6% 8%
PV of 0 0 69.3 59.4 104.0 89.0
interest
PV of 30.7 20.8 30.7 20.8 30.7 20.8
principal
Bond 30.7 20.8 100 80.2 134.7 109.8
price
% price -32.2 -19.8 -18.5
change

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Relationship 6

6. Bond price volatility increase when bonds are sold at the lower
yield to maturity
Example
Bond A has maturity 25 year, coupon rate 9%/year, face value
$100, pay interest annually. Determine bond price sensitivity
when interest rates change?

Relationship 6

Bond price (Maturity: 25 years)

YTM 7% 8% 9% 10% 11% 12%
PV of 104.9 96.1 88.4 81.7 75.8 70.6
interest
PV of 18.4 14.6 11.6 9.2 7.4 5.9
principal
Bond 123.3 110.7 100 90.9 83.2 76.5
price
% price -10.2 -9.1 -8.0
change

Measure price volatility

Price volatility

Modified Convexity
Duration
duration

75

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(1) Duration

- Macaulay Duration (D)

- It is necessary time to receive all cash flows when
investing in bonds 76

Duration

•  Macaulay duration
The duration of a bond was a more appropriate measure
of time characteristics than the term to maturity of the
bond because duration con- siders both the repayment
of capital at maturity and the size and timing of coupon
payments prior to final maturity.

= Macaulay duration
From bond pricing formula:

To determine the approximate change in price for a small change in yield, the
first derivative of equation with respect to required yield can be computed as:

78

26
 12/18/19

Macaulay duration

[ t
wt = CF t (1 + r ) P ]
T
D= ∑ t ×w t

t =1
79

DURATION

•  Formula:

C : coupon interest
r : yield
F : Face value
P : Bond price
T: time to maturity
t: time of each cash
flow

Example

•  Safe fund has bought 1 bond with face value

$1000000, coupon rate 5.3%, 5 years to maturity, pay
interest semi-annually at price $970144.29. Yield to
maturity is 6%. Determine duration of this bond?

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Half- Cash Flow PV of cash flow PV(Ct)/P (PV(Ct)/P)xt

year
(at 3% YTM)
1 26500 25728.16 0.0265 0.03
2 26500 24978.79 0.0257 0.05
3 26500 24251.25 0.0250 0.07
4 26500 23544.91 0.0243 0.10
5 26500 22859.13 0.0236 0.12
6 26500 22193.33 0.0229 0.14
7 26500 21546.93 0.0222 0.16
8 26500 20919.34 0.0216 0.17
9 26500 20310.04 0.0209 0.19
10 1026500 763812.40 0.7873 7.87
970144.29 8.89 (half-years)
4.45 (years)

DURATION

Ø Bond A has 3 years to maturity, coupon rate

8%/year, face value $1000, pays interest
annually.
Ø Bond B is a zero coupon bond- 3 years to
maturity.
Ø YTM of A and B is 10%/year
•  Determine duration of A and B ?

DURATION CHARACTERISTICS

•  Duration of a bond with coupon payments always will

be less than its term to maturity. A zero-coupon bond
has duration equal to its term to maturity because the
only cash flow comes in the final year.
•  There is an inverse relationship between coupon and
duration. A bond with a larger coupon will have a
shorter duration because more of the total cash flows
come earlier in the form of interest payments.

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DURATION CHARACTERISTICS

•  There is a positive relationship between term to

maturity and duration. Note that the duration of a
coupon bond increases at a decreasing rate with
maturity.
•  There is an inverse relationship between yield to
maturity and duration. A higher yield to maturity of a
bond reduces its duration.

DURATION CHARACTERISTICS

•  4 bonds have the similar face value $100, pay

interest semi-annually.
•  Bond A: Coupon rate 6%, maturity 5 years

•  Bond B: Coupon rate 6%, maturity 20 years

•  Bond C: Coupon rate 9%, maturity 5 years

•  Bond D: Coupon rate 9%, maturity 20 years

DURATION CHARACTERISTICS

YTM Duration
6%/ 5 years 6%/ 20 years 9%/ 5 years 9%/ 20 years

4% 4.490 13.081 4.318 12.141

5% 4.477 12.621 4.303 11.694
6% 4.465 12.158 4.287 11.248
7% 4.452 11.693 4.271 10.808
8% 4.439 11.231 4.255 10.374

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DURATION AND INTEREST RATE RISK

v  D: duration
v  y: yield to maturity
v  ∆y: interest rate change
v  ∆P: price change
v  P: bond price

Quiz

•  A bond has duration 3.6 year. If market

interest rate decrease from 8% to 5%, bond
price will:
A.  Decrease 10%
B.  Increase 10%
C.  Be unchanged
D.  Increase 3%

DURATION AND INTEREST RATE RISK

•  Modified duration

•  Bond price percentage change

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DURATION

•  Bond A has 30 years to maturity, coupon rate 8%/

year, pays interest annually. Yield to maturity is 9%/
year. This bond is sold at $897.26, bond duration is
11.37 years. If YTM increase to 9.1%, determine
bond price change based on duration.

Portfolio duration

•  A portfolio has 2 assets. Asset A value is $300

millions, duration is 2.3. Asset B value is $700
millions, duration is 3.6. Determine the portfolio
duration?

BOND PRICE CHANGE

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 12/18/19

Convexity

•  Formula:

•  Percentage price change:

Convexity

•  Bond A has 5 years to maturity, coupon rate 8%/year,

face value $100. This bond pays interest annually,
yield to maturity is 9%/year. This bond is sold at
$96.11. Determine convexity.

CONVEXITY

Year CF t(t+1)CF

1 8$ 0.7722 16 12.3552
2 8$ 0.7084 48 34.0032
3 8$ 0.6500 96 62.4000
4 8$ 0.5963 160 95.4080
5 108$ 0.5470 3240 1772.2800
Sum 3560 1976.446

Convexity = 1976.446/ 96.11

= 20.56

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Convexity characteristics

•  There is an inverse relationship between coupon and convexity

(yield and maturity constant)- that is lower coupon, higher
convexity.
•  There is a direct relationship between maturity and convexity
(yield and coupon constant)- that is longer maturity, higher
convexity.
•  There is an inverse relationship between yield and the convexity
along the price- yield curve (coupon and maturity constant). This
means that the price-yield curve is more convex at lower yields
and lexx convex at higher yields.

Application

(1) Why do investors prefer convexity?

Δ P ($)

Bond B
Bond A

Δ YTM (%)

Which bond has higher convexity?

Which bond has been prefer?
“There is no free lunch”

Example 2

•  Government bond, issued on March, 2008, has 5

years to maturity, face value 1 millions dong, coupon
rate 10%/year, pays interest annually. Interest rate on
March, 2010, is 12.5%/ year. Determine convexity?

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Application

(2) When interest rate is forecast to increase or

decrease, what should investor change their
bond portfolio to get profit?

100

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CHAPTER 3

STOCK ANALYSIS AND VALUATION

FUNDAMENTAL ANALYSIS

q Intrinsic value comes from its earnings prospects determined by:

•  The global economic environment

•  Economic factors affecting the firm’s industry

•  The position of the firm within its industry

FUNDAMENTAL ANALYSIS

Macroeconomic analysis

CONTENT

3 2

Company analysis Industry analysis

1  
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FUNDAMENTAL ANALYSIS
q There are two main methods in fundamental analysis:
•  Top – down approach
•  Bottom – up approach

1   2   3  

•  Macroeconomic •  Industry •  Company

analysis analysis analysis
•  (Economy) •  (Industry) •  (Company)

If analysts implements the process from 1 to 3: Top – down approach and vice versa

TOP – DOWN APPROACH

Which countries will have good

Step 1 Economy potential for economic growth?
Then, choose the good countries

Which industries will be better?

Step 2 Industry (in good countries). Then, choose
the potential industries

Which companies (in potential

Step 3 Company
industries) should be invested?

5  

MACROECONOMIC ANALYSIS

•  There is a strong connection between countries, therefore, domestic

economic is influenced by global economy. In fundamental analysis,
macroeconomic analysis process must analyze both :
q Global economy
q Domestic economy

2  
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MACROECONOMIC ANALYSIS

q Resources
•  IMF: World Economic Outlook
•  World Bank: Global Economic Prospects
•  Macroeconomic report from securities companies, investment banks,
such as: Goldman sachs, JP Morgan, Morgan Stanley…

GLOBAL ECONOMY

•  International economy affects firm prospects

•  Performance in countries and regions can be highly variable

•  Harder for businesses to succeed in contracting economies than in

expanding ones

GLOBAL ECONOMY

q Political risk:
•  Greek and Spanish economies

•  U.S. fiscal cliff

q Exchange rate risk:

•  Changes the prices of imports and exports

•  Changes the volumes of imports and exports

•  Trade war US - China

3  
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GLOBAL ECONOMIC PERFORMANCE

Source:  Sta3sta.com    

TOP 10 EXPORT COUNTRIES IN 2017

Source:  Sta3sta.com    

MACROECONOMIC INDICATORS

Commodi3es  price   Consumer  confidence   Consumer  confidence  

4  
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MACROECOMIC INDICATORS

The Domestic Macro economy:

q Key Variables
•  Gross domestic product (GDP)
•  Unemployment rates
•  Inflation (CPI)
•  Interest rates
•  Budget deficit

GDP growth Vietnam (2007 – 2018)

Source:  Gso.gov.vn  

5  
 12/18/19  

GDP comparison with other countries

Source:  Gso.gov.vn  

MACROECONOMIC POLICY

q Monetary policy

•  Interest rate

•  Money supply

q Fiscal policy

•  Tax

•  Government expenditure

INDUSTRY ANALYSIS

•  Similar to an ailing macro economy, it is unusual for a firm in a

troubled industry to perform well

•  Economic performance can vary widely across industries

•  Therefore, finding potential industry is essential to find potential

stock.

6  
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Return on equity in US (2015 – 2016)

Source:  Bodie,  Kane,  Marcus  (11th)  

Industry stock price return in US

Source:  Bodie,  Kane,  Marcus  (11th)  

INDUSTRY ANALYSIS

Three factors determine a firm’s sensitivity to the business cycle:

1.  Sensitivity of sales

•  Necessities vs. discretionary goods
•  Items that are not sensitive to income levels (such as tobacco and movies) vs. items that are,
(such as machine tools, steel, autos)

2.  Operating leverage

•  Firms with low operating leverage (less fixed assets) are less sensitive to business conditions
•  Firms with high operating leverage (more fixed assets) are more sensitive to the business
cycle

3.  Financial leverage

•  Interest is a fixed cost that increases the sensitivity of profits to the business cycle

7  
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INDUSTRY ANALYSIS

Industry  cyclicality:  Growth  of  sales,  year  over  year,  in  two  
industries;  sales  of  jewelry  show  much  greater  varia3on  than  
sales  of  groceries  

INDUSTRY LIFE CYCLE

INDUSTRY STRUCTURE AND PERFORMANCE

q Five Determinants of Competition

1.  Threat of entry

2.  Rivalry between existing competitors

3.  Pressure from substitute products
4.  Bargaining power of buyers
5.  Bargaining power of suppliers

8  
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COMPANY ANALYSIS

•  Although, there are many companies operates in same industry, their

operating performance is very different. Therefore, stock analyst should do
company analysis
q Company analysis
•  Analyze business model of company
•  Analyze competitive advantage of company in market
•  Analyze financial condition and operating performance of company

COMPETITIVE ADVANTAGE OF COMPANY

Micheal Porter Five Forces Strategy

COMPANY BUSINESS STRATEGY

q Low – cost strategy

o Seeks to be the low cost leader in its industry

o Through economies of scale (in production or

marketing), better logistics, Must still
command prices near industry average, so
still must differentiate

9  
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DIFFERENTIATION STRATEGY

q Differentiation strategy

•  Identify as unique in its industry in

an area that is important to buyers

•  Above average rate of return only

comes if the price premium exceeds
the extra cost of being unique

SWOT ANALYSIS

•  Examination of a firm’s:

• Strengths
• Weaknesses
• Opportunities
• Threats

Types of Companies and Stocks

•  Growth

•  Defensive

•  Cyclical

•  Speculative

10  
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GROWTH COMPANIES

•  Growth companies have historically been defined as companies that

consistently experience above-average increases in sales and earnings

•  Financial theorists define a growth company as one with management

and opportunities that yield rates of return greater than the firm’s
required rate of return

GROWTH STOCKS

•  Growth stocks are not necessarily shares in growth companies

•  A growth stock has a higher rate of return than other stocks with similar risk

•  Superior risk-adjusted rate of return occurs because of market

undervaluation compared to other stocks

VALUE VERSUS GROWTH INVESTING

•  Growth stocks will have positive earnings surprises and above-average risk
adjusted rates of return because the stocks are undervalued
•  Value stocks appear to be undervalued for reasons besides earnings growth
potential
•  Value stocks usually have low P/E ratio or low ratios of price to book value

11  
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DEFENSIVE COMPANIES AND STOCKS

•  Defensive companies’ future earnings are more likely to withstand an economic

downturn

•  Low business risk

•  Not excessive financial risk

•  Stocks with low or negative systematic risk

CYCLICAL COMPANIES AND STOCKS

•  Sales and earnings heavily influenced by aggregate business activity

•  Stocks with high betas

•  For instance: Car industry, real estate industry

STOCK VALUATION

12  
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THE PURPOSE OF VALUATION

•  Good companies are not necessarily good investments

•  Identify the mispriced stocks then give investment advice for investors

•  In other words, there are two main steps in investment process in fundamental analysis

Step 1: Measure “intrinsic” value of stock by valuation models.

Step 2: Compare “market price” versus “intrinsic value” of stock

q If Market price is bigger than intrinsic value, it means that the stock is overvalued,
investor should sell the stock or shouldn’t buy that stock

q If Market price is smaller than intrinsic value, it means that the stock is undervalued,
investor should buy the stock.

EQUITY VALUATION MODELS

•  Balance Sheet Models

•  Dividend Discount Models (DDM)

•  Price/Earnings Ratios

•  Free Cash Flow Models

Dividend Discount Models (DDM)

D1 D2 D3
V0 = + + + ...
1 + k (1 + k )2 (1 + k )3

•  V0 =current value; Dt=dividend at time t; k = required rate of

return
•  Stock price should equal the present value of all expected future
dividends into perpetuity.
•  There are 3 types of dividend discount models:
q Zero growth
q Constant growth
q Non – constant growth

13  
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Dividend Discount Models (DDM)

•  Zero – growth model
D1 D2 D3
V0 = + + + ...
1 + k (1 + k )2 (1 + k )3
Zero – growth means g = 0, therefore
D0 = D1 = D2 = D3 = ... = D∞ = D
D D D D
V0 = + + + ... =
1 + k (1 + k )2 (1 + k )3 k
18-­‐40  

Dividend Discount Models (DDM)

•  Zero – growth model

•  Example 1:
•  ANZ preferred stock has $50 par value with 6%
dividend yield. If the required rate of return is 10%,
what is the value of stock?

Dividend Discount Models (DDM)

•  Zero – growth model

•  Example 1:

D 50 * 6%
V0 = = = 30
k 10%

Intrinsic value equals $30. It implies that:

1)  If market price > 30, investor shouldn’t buy the stock
2)  If market price < 30, investor should buy the stock
18-­‐42  

14  
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Dividend Discount Models (DDM)

•  Constant growth model

D0 (1 + g ) D1
V0 = =
k−g k−g

g=dividend growth rate

18-­‐43  

Dividend Discount Models (DDM)

Constant growth:

D0 (1 + g ) D1
V0 = =
k−g k−g

g=dividend growth rate

18-­‐44  

Dividend Discount Models (DDM)

•  Constant growth

•  Example 2

•  The company has just paid its annual dividend of $2

per share and dividends are expected to grow at a rate
of 5% per year to infinity. If the required rate of return
is 10%, what is the value of stock?

18-­‐45  

15  
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Dividend Discount Models (DDM)

D0 (1 + g ) 2 * (1 + 5%)
V0 = = = 42
k−g 10% − 5%

Intrinsic value equals $42. It implies that:

1)  If market price > 42, investor shouldn’t buy the stock
2)  If market price < 42, investor should buy the stock

18-­‐46  

Dividend Discount Models (DDM)

•  Constant growth
•  Example 3

•  The expected dividend in coming year is $2 and dividends are

expected to grow at a rate of 6% per year to infinity. If the required

rate of return is 10%,

1)  what is the value of stock?

2)  If the current price of stock is $36. How the investor should do

in this case?

18-­‐47  

Dividend Discount Models (DDM)

D1 2*
V0 = = = 50
k − g 10% − 6%

1)  Intrinsic value equals $50.

2)  If the market price of stock is $36. Therefore, investor should
buy the stock.

18-­‐48  

16  
 12/18/19  

Dividend Discount Models (DDM)

•  Non - constant growth

•  Example 4
•  The company has just paid its annual dividend of $3 per
share and dividends are expected to grow at a rate of 10%
per year over next 3 years. Then, growth rate of dividend
will be 5% to infinity. If the required rate of return is 8%,
what is the value of stock? How the investor should do if the
market price is $140

18-­‐49  

Dividend Discount Models (DDM)

•  Example 4: k = 8%
•  D1 = D0*(1 + 10%) = 3*1.1 = 3.3
•  D2 = D0*(1+10%)^2 = 3*1.1^2 = 3.63
•  D3 = D0*(1+10%)^3 = 3.993
•  Then g = 5% to infinity
D1 D2 D3 P3
V0 = + + +
1+ k (1 + k )2 (1 + k )3 (1 + k )3

D1 D2 D3 D3 * (1 + g )
V0 = + + + = 120.27
1 + k (1 + k )2 (1 + k )3 (k − g )(1 + k )3
18-­‐50  

Dividend Discount Models (DDM)

•  Non - constant growth

•  Example 4
•  From dividend model, intrinsic value of stock is
$120.27. If the market price of stock is $140, it
means that the stock is overvalued. Therefore, the
investor shouldn’t buy this stock.

18-­‐51  

17  
Questions to be answered:
•  What do we mean by risk aversion?
•  What are the basic assumptions behind the
Markowitz portfolio theory?
•  What is meant by risk and how do we measure it?
•  How do we compute
•  the expected rate of return for an individual risky asset
or a portfolio of assets?
•  the standard deviation of rates of return for an
individual risky asset or a portfolio?
•  What is meant by the covariance between rates of return and how do you
compute covariance?

§ Given the formula for the standard deviation of a

portfolio, how and why do you diversify a portfolio?
§ What happens to the standard deviation of a portfolio
when you change the correlation between the assets
in the portfolio?
§ What is the risk-return efficient frontier?
§ Is it reasonable for alternative investors to select
different portfolios from the portfolios on the efficient
frontier?
§ What determines which portfolio on the efficient
frontier is selected by an individual investor?

1
§ As an investor you want to maximize the
returns for a given level of risk.
§ Your portfolio includes all of your assets and
liabilities
§ The relationship between the returns for assets
in the portfolio is important.
§ A good portfolio is not simply a collection of
individually good investments.

§ Given a choice between two assets with equal

rates of return, most investors will select the
asset with the lower level of risk.
§ Most investors are risk averse:
§  Many investors purchase insurance for: Life,
Automobile, Health, and Disability Income. The
purchaser trades known costs for unknown risk of loss
§  Yield on bonds increases with risk classifications from
AAA to AA to A….
§ But not all
§  Risk preference may have to do with amount of money
involved - risking small amounts, but insuring large
losses

No general agreement as to what it means

1.  Uncertainty of future outcomes
-  A project in a volatile country is more risky
-  Investing during a depression is more
risky
or
2. Probability of an adverse outcome
- A stock with higher variance is more risky
- A portfolio with negative skewness is more
risky

2
§ Quantifies risk
§ Derives the expected rate of return for a portfolio of
assets and an expected risk measure
§ Shows that the variance of the rate of return is a
meaningful measure of portfolio risk
§ Derives the formula for computing the variance of a
portfolio, showing how to effectively diversify a
portfolio

1.  Investors consider each investment alternative as being

presented by a probability distribution of expected
returns over some holding period.
2. Investors minimize one-period expected utility, and their
utility curves demonstrate diminishing marginal utility of
wealth.
3.  Investors estimate the risk of the portfolio on the basis of
the variability of expected returns.
4.  Investors base decisions solely on expected return and
risk, so their utility curves are a function of expected
return and the expected variance (or standard deviation)
of returns only.
5.  For a given risk level, investors prefer higher returns to
lower returns. Similarly, for a given level of expected
returns, investors prefer less risk to more risk

Using these five assumptions, a single asset

or portfolio of assets is considered to be
efficient if no other asset or portfolio of assets
offers higher expected return with the same (or
lower) risk, or lower risk with the same (or
higher) expected return.

3
§ Variance or standard deviation of expected
return
§ Range of returns
§ Returns below expectations
§ Semivariance – a measure that only
considers deviations below the mean
§ These measures of risk implicitly assume
that investors want to minimize the damage
from returns less than some target rate

§ For an individual asset - sum of the potential

returns multiplied with the corresponding
probability of the returns
§ For a portfolio of assets - weighted average of
the expected rates of return for the individual
investments in the portfolio

Possible Rate of Expected Return

Probability Return (Percent) (Percent)
0.25 0.08 0.0200
0.25 0.10 0.0250
0.25 0.12 0.0300
0.25 0.14 0.0350
E(R) = 0.1100

4
 (Percent of Portfolio) Return (E[Ri ]) Return (Wi XE[Ri ])

0.20 0.10 0.0200

0.30 0.11 0.0330
0.30 0.12 0.0360
0.20 0.13 0.0260
E(Rpor) = 0.1150

n
E(R por ) = ∑ Wi × E(R i )
i=1

where:
Wi = the percent of the portfolio in asset i
E(R i ) = the expected rate of return for asset i

§ Variance is a measure of the variation of possible

rates of return Ri, from the expected rate of return
[E(Ri)] n
Variance = σ 2 = ∑ Pi × [R i -E(R i )]2
i =1

§  where Pi is the probability of the possible rate of return,

Ri
§ Standard deviation is the square root of the
variance St. Dev. = σ = σ 2

Possible Rate Expected

of Return (R i ) Return E(Ri ) Ri - E(Ri ) [Ri - E(Ri )]2 Pi [Ri - E(Ri )]2 Pi

0.08 0.11 0.03 0.0009 0.25 0.000225

0.10 0.11 0.01 0.0001 0.25 0.000025
0.12 0.11 0.01 0.0001 0.25 0.000025
0.14 0.11 0.03 0.0009 0.25 0.000225
0.000500

Variance ( σ 2) = .00050
Standard Deviation (σ ) = .02236

5
 Computation of Monthly Rates of Return
Closing Closing
Date Price Dividend Return (%) Price Dividend Return (%)
Dec.00 60.938 45.688
Jan.01 58.000 -4.82% 48.200 5.50%
Feb.01 53.030 -8.57% 42.500 -11.83%
Mar.01 45.160 0.18 -14.50% 43.100 0.04 1.51%
Apr.01 46.190 2.28% 47.100 9.28%
May.01 47.400 2.62% 49.290 4.65%
Jun.01 45.000 0.18 -4.68% 47.240 0.04 -4.08%
Jul.01 44.600 -0.89% 50.370 6.63%
Aug.01 48.670 9.13% 45.950 0.04 -8.70%
Sep.01 46.850 0.18 -3.37% 38.370 -16.50%
Oct.01 47.880 2.20% 38.230 -0.36%
Nov.01 46.960 0.18 -1.55% 46.650 0.05 22.16%
Dec.01 47.150 0.40% 51.010 9.35%
E(RCoca-Cola)= -1.81% E(Rhome
E(RExxon)=
Depot)= 1.47%

§  A measure of the degree to which two variables “move together” relative to
their individual mean values over time

§  For two assets, i and j, the covariance of rates of return is defined as:

Covij = E{[Ri - E(Ri)][Rj - E(Rj)]}

§ The correlation coefficient is obtained by

standardizing (dividing) the covariance by the
product of the individual standard deviations

§ Correlation coefficient varies from -1 to +1

Cov ij
rij =
σ iσ j

where :
rij = the correlation coefficient of returns
σ i = the standard deviation of R it
σ j = the standard deviation of R jt

6
 n n n
2 2
σ port = ∑w σ
i =1
i i + ∑∑ w i w j Cov ij
i =1 i =1

where :
σ port = the standard deviation of the portfolio
Wi = the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
σ i2 = the variance of rates of return for asset i
Cov ij = the covariance between the rates of return for assets i and j,
where Cov ij = rijσ iσ j

§ Any portfolio of assets may be described by

two characteristics:
§ The expected rate of return
§ The expected standard deviations of returns
§ The correlation, measured by covariance,
affects the portfolio standard deviation
§ Low correlation reduces portfolio risk while not
affecting the expected return

Asset E(R i ) Wi σ 2i σi
1 .10 .50 .0049 .07
2 .20 .50 .0100 .10
Case Correlation Coefficient Covariance
a +1.00 .0070
b +0.50 .0035
c 0.00 .0000
d -0.50 -.0035
e -1.00 -.0070

7
§ Assets may differ in expected rates of return
and individual standard deviations
§ Negative correlation reduces portfolio risk
§ Combining two assets with -1.0 correlation
reduces the portfolio standard deviation to
zero only when individual standard deviations
are equal

Asset E(R i )
1 0.10 rij = 0.00
2 0.20
Case W1 W2 E(Ri )

f 0.00 1.00 0.20

g 0.20 0.80 0.18
h 0.40 0.60 0.16
i 0.50 0.50 0.15
j 0.60 0.40 0.14
k 0.80 0.20 0.12
l 1.00 0.00 0.10

Expected return and expected standard

deviation for the 7 portfolios
Case W1 W2 E(Rport) σ(Rport)

f 0.00 1.00 0.20 0.1000

g 0.20 0.80 0.18 0.0812
h 0.40 0.60 0.16 0.0662
i 0.50 0.50 0.15 0.0610
j 0.60 0.40 0.14 0.0580
k 0.80 0.20 0.12 0.0595
l 1.00 0.00 0.10 0.0700

8
 E(R)
0.20 2
With two perfectly
correlated assets, it
0.15
is only possible to Rij = +1.00
create a two asset
0.10 portfolio with risk- 1
return along a line
0.05 between either
single asset
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return

E(R) f
0.20 2
With uncorrelated g
h
assets it is possible i
0.15 j
to create a two Rij = +1.00
asset portfolio with
0.10 k
lower risk than 1
either single asset Rij = 0.00
0.05

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return

E(R) f
0.20 2
With correlated g
h
assets it is possible i
0.15 j
to create a two Rij = +1.00
asset portfolio
0.10 k Rij = +0.50
between the first 1
two curves Rij = 0.00
0.05

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return

9
 E(R) With Rij = -0.50 f
0.20 negatively 2
g
correlated h
assets it is i
0.15 j
possible to Rij = +1.00
create a two k Rij = +0.50
0.10 asset portfolio 1
with much Rij = 0.00
0.05 lower risk than
either single
asset
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return

E(R) Rij = -0.50 f

0.20 Rij = -1.00 2
g
h
0.15 i
j Rij = +1.00
0.10 k Rij = +0.50
1
Rij = 0.00
0.05 With perfectly negatively correlated
assets it is possible to create a two asset
portfolio with almost no risk
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return

§ Results of portfolio allocation depend on

accurate statistical inputs
§ Estimates of
§ Expected returns
§ Standard deviation
§ Correlation coefficient
§ Among entire set of assets
§ With 100 assets, 4,950 correlation
estimates
§ Estimation risk refers to potential errors

10
 § The efficient frontier represents that set of
portfolios with the maximum rate of return for
every given level of risk, or the minimum risk for
every level of return
§ Frontier will be portfolios of investments rather
than individual securities
§ Exceptions being the asset with the highest
return and the asset with the lowest risk

Efficient B
E(R) Frontier

A C

Standard Deviation of Return

§  An individual investor’s utility curve specifies the trade-

offs he is willing to make between expected return and
risk
§  The slope of the efficient frontier curve decreases
steadily as you move upward
§  These two interactions will determine the particular
portfolio selected by an individual investor
§  The optimal portfolio has the highest utility for a given
investor
§  It lies at the point of tangency between the efficient
frontier and the utility curve with the highest possible
utility

11
E(R port )
U3’
U2’
U1’

U3 X

U2
U1

E(σ port )

12