INVESTMENT

ANALYSIS
AGENDA

• What is an Investment?
• Return of an asset
• Historical return
• Expected return

• Risk of an asset
• Historical risk
• Expected risk
WHAT IS AN INVESTMENT?

• Investment is the current commitment of funds for a period of time in order to derive
future payments that will compensate the investor for
1. the time the funds are committed,
2. the expected rate of inflation during this time period, and
3. the uncertainty of the future payments

• The investor is trading a known dollar amount today for some expected future stream of
payments that will be greater than the current dollar amount today
WHAT IS AN INVESTMENT?

• Investment is the current commitment of funds for a period of time in order to derive
future payments that will compensate the investor for
1. the time the funds are committed – time value of money
2. the expected rate of inflation during this time period – inflation expectations
3. the uncertainty of the future payments – investment risk
RETURN

• Return is the primary motive that drives investment

• It represents the reward for undertaking an investment
• The following are the two main types of return from the perspective of an investment:

Types of return

Current return Capital return

MEASURING HISTORICAL RETURN

• Current return for a given period is calculated as

𝐶𝑎𝑠h 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑒𝑡𝑢𝑟𝑛=
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡h𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

• Capital return for a given period is calculated as

𝑃𝑟𝑖𝑐𝑒 𝑐h𝑎𝑛𝑔𝑒𝑜𝑣𝑒𝑟 𝑡h𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛=
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒𝑜𝑓 𝑡h𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Total return = Current return + Capital return

Note: Historical return is also called ex-post return
MEASURING HISTORICAL RETURN

• You bought 10 shares of RELIANCE a year ago at ₹2400 per share. You decide to sell
the shares at the current market price of RELIANCE which is ₹2580 per share. During
the year, you received a dividend of ₹10 per share.
• Compute your current return, capital return, and the total return on this investment.
RISK

• Risk refers to the probability that the actual outcome of an investment will differ from the
expected outcome
• Investors are concerned the actual outcome will be less than the expected outcome
• Thus, risk represents the fear of loss of capital, either partially or in its entirety
• The wider the range of possible outcomes, the greater the risk
SOURCES OF RISK
• Three key sources of risk for an investment are:

Business risk
• Risk of poor business performance
• Risk of strikes, fires, sudden management changes etc.

Interest rate risk

• Changes in interest rates affect prices of debentures and fixed
income securities
• Interest rates also indirectly affect the price of equities

Market risk
• Risk of changing investor sentiment because of changing
geopolitical conditions
MEASURING HISTORICAL RISK

• Risk refers to the possibility that the actual outcome of an investment will differ from the
expected outcome
• Risk is dependent on the variability or dispersion of returns. If an asset’s return has no
variability, it is riskless
• Most commonly used measure of risk in finance is variance or the standard deviation
of returns
MEASURING HISTORICAL RISK

• A stock gave the following returns in each of the last 6 years:

Year Return (Ri)

Year 1 15%
Year 2 12%
Year 3 20%
Year 4 -10%
Year 5 14%
Year 6 -9%

• Compute the risk of the stock measured in terms of standard deviation of its returns
MEASURING EXPECTED RETURN

• Probability Distribution
• Probability of an event represents the likelihood of its occurrence
• What do you think is the probability of the stock of Reliance giving a positive return in the
year 2023-24?
• Consider the following returns of Reliance in the year 2022.

Rate of return % Probability of occurrence

20 0.20
5 0.30
-10 0.50
MEASURING EXPECTED RETURN

• Expected rate of return is the weighted average of the possible returns multiplied by their
respective probabilities
𝑛
𝐸 ( 𝑅 )=∑ 𝑅 𝑖 𝑝 𝑖
𝑖=1

Where,
E(R) = expected return from the stock
Ri = return from stock under state i

pi = probability of occurrence of the state I

n = no. of states
Note: Expected return is also called ex-ante return
MEASURING EXPECTED RETURN

• Compute the expected return of Reliance for the year 2022

MEASURING EXPECTED RISK

• Expected risk is the standard deviation of expected returns under different probability
states

𝜎 =∑ 𝑝𝑖 ( 𝑅𝑖 −𝐸(𝑅))
2 2

Where, = variance of returns of the stock

Standard deviation will be square root of variance
MEASURING EXPECTED RISK

• Compute the expected risk of Reliance for the year 2022

State of the pi Ri piRi Ri – E(R) (Ri – E(R))2 pi(Ri – E(R))2

economy
Boom 20
Normal 5
Recession -10