Finance and Banking Lesson 5

Stock Valuation
(1) Using dividends
(2) Using market comparables

Price = Earnings per share x Price to Earnings ratio

(EPS) (P/E)

Net income / no. of shares Industry Average

Hybrid Securities
Financial Assets

Bonds (Debt) Common Stocks (Equity)

Hybrid Securities

Example: Preferred stock

Characteristic from Debt: Fixed dividend
Characteristic from Equity: No maturity (perpetual)
Example: Convertible Bond
(3-year)
|------------------|-------------------|-------------------|
0 1 2 3
C C C + Face Value

No. of shares
Conversion = Predetermined

Possibility no. of shares x market price (3-years time)

> Face Value

Before maturity  Bond

At maturity  Common shares
Risk and Return
Investment A return = 10%
Investment B return = 20%
“High risk  High return”

Define: Risk = Uncertainty that can be quantified  can be

measured  can be managed

How to measure risk? Range of possible returns

Asset Classes Range of returns

Lowest risk 0 % to 10%
Treasury Bill (narrow range)

Highest risk -30% to 100%

Small stocks (wide range)

Narrow range  Low risk

Wide range  High risk
How to measure range of returns?
Dispersion/Distribution of returns  Distribution Curve
(Normal/Uniform)
X Standard Deviation

-Sd +Sd

| |
Low High

Higher standard deviation  Higher risk

Lower standard deviation  Lower risk

A B
Define: Standard Deviation (Sd)
 Dispersion from mean / expected return

Expected return = Pr1xR1 + Pr2xR2 + … Prn x Rn

where Pr = Probability
and Pr1 + Pr2 + .. Prn = 1

Expected return = X
= 0.1x0.09 + 0.2x0.10 + 0.4x0.11 + 0.2x0.12 + 0.1x0.13
= 0.11 or 11%

Sd
= [Pr1(R1 – X)^2 + Pr2(R2 – X)^2 +… Prn(Rn – X)^2]^0.5
= [0.1(0.09-0.11)^2 + 0.2(0.1-0.11)^2 + 0.4(0.11-0.11)^2 +
0.2(0.12-0.11)^2 + 0.1(0.13-0.11)^2]^0.5
= 1.095%
Var = [Pr1(R1 – X)^2 + Pr2(R2 – X)^2 +… Prn(Rn – X)^2]
(Variance)

Sd = [Var]^0.5
Var = Sd^2
Expected return = 11% +/- 1.095%
Most likely
|---------------------|------------------------|
11%
Low High
11% - 1.095 11% + 1.095

Return Risk
Investment A 30% 15%
Investment B 20% 15%

Investment C 25% 20%

Investment D 25% 10%

Investment E 30% 28%

Investment F 20% 17%

Coefficient of Variation (CV)

= Standard Deviation / Expected return = Sd / X
 Measures risk-return trade-off  the return is worth the
risk taken
Select the lower CV  better risk-return trade-off
You are the investment manager in PASCO Ltd, and you are considering the investments of
Delta Ltd and Force Ltd. The following projected performance for the next four years is
supplied by a fund manager:

Probability Year Delta (%) Force (%)

0.25 1 32.00 4.00

0.25 2 (6.00) 36.00

0.25 3 22.00 12.00

0.25 4 (5.00) 32.00

(a) What is the expected rate of return and standard deviation for each of these two
investments?

(b) Which investment would you choose if you are considering investing in only one
company? Explain.

(a)

Delta Ltd:
(b) Expected return (c) = (d) = (e) =

(a) % (a) x (b) (b) - Exp. ret (c ) x (c) (a) x (d)

0.25 32.00 8.00 21.25 451.56 112.89

0.25 (6.00) (1.50) (16.75) 280.56 70.14

0.25 22.00 5.50 11.25 126.56 31.64

0.25 (5.00) (1.25) (15.75) 248.06 62.02

EXPECTED

1.00 RETURN = 10.75 TOTAL = 276.69

Standard Deviation Sq Root = 16.63

Coefficient of Variation = 1.55

Force Ltd:
% (c) = (d) = (c ) x (c) (e) = (a) x (d)

(a) (b) (a) x (b) (b) - Exp. Ret

0.25 4.00 1.00 (17.00) 289.00 72.25

0.25 36.00 9.00 15.00 225.00 56.25

0.25 12.00 3.00 (9.00) 81.00 20.25

0.25 32.00 8.00 11.00 121.00 30.25

EXPECTED

1.00 RETURN = 21.00 % TOTAL = 179.00

Standard Deviation Sq Root = 13.38 %

Coefficient of Variation = 0.64

(b) The expected return of Force Ltd is higher, and the standard deviation of Force Ltd is lower,
so Force Ltd is preferred if stand alone investment is considered. This is also shown by the
lower coefficient of variation number shows that Force has a better risk-return trade-off.
(For the risk of 13.38%, the return of 21% is worth the risk)

Single Asset Investment risk and return

(1)Expected return = Pr1xR1 + Pr2xR2 + … Prn x Rn
(2)Sd
= [Pr1(R1 – X)^2 + Pr2(R2 – X)^2 +… Prn(Rn – X)^2]^0.5
(3)Coefficient of Variation (CV)
= Standard Deviation / Expected return = Sd / X
Alternative method for returns:
Property: Rent
Return ($) = Psell – Pbuy + Cash Flow
Bonds: Coupons

Shares: Dividends

Return (%) = (Psell – Pbuy + Cash Flow) / Pbuy x 100 = %

Single Period returns = 1 year or less

Portfolio Investment risk and return

Define: Portfolio – 2 or more assets
 Spread the risk / Diversification  reduce risk

How to diversify? How to select assets into portfolio?

Random diversification  inefficient
MPT – Modern Portfolio Theory  Scientific Diversification
(Markowitz)  Efficient
Select assets that are negatively correlated or not correlated
with one another.
Positive Correlation – move in the same direction to the same
event
Example:
SIA AirAsia Qantas
If oil prices increase
Profit Down Down Down
Share price Down Down Down

Negative Correlation - move in the opposite direction to the

same event
Example:
SIA Shell Petroleum
If oil prices increase
Profit Down Up
Share price Down Up

No correlation
Example:
SIA BreadTalk
If oil prices increase
Profit Down No change
Share price Down No change
Total Risk

Unsystematic risk (Specific/Unique)

Systematic risk (Market)

No. of assets
0 1 2 3 4 ….
15 – 20
High systematic risk -------- High returns
Correlation coefficient  -1 < p < +1
pAB, p12

(A)p = +1  Perfect positive correlation X

Eg. X up 10%, Y up 10%
(B)p = +0.5  Positive correlation (4)
Eg. X up 10%, Y up 6%
(C)p = 0  No correlation (3)
(D)p = -1  Perfect negative correlation (1)
Eg. X up 10%, Y down 10%
(E)p = -0.5  Negative correlation (2)
Eg. X up 10%, Y down 6%