Meaning of Return

Every investment has a speculative component. The degree?

of that speculation typically defines the product's rate of
return.

Money earned or lost on a specific amount of investment

over a specified period of time.

Absolute return is the return that an asset or portfolio

achieves over a specified period. This return can be positive
or negative. It is expressed as a percentage, and it considers
the appreciation or depreciation of the asset.

Historical Return vs Expected Return |

Measuring Historical Return

Historical Return = D0 + (P1— P0) *100

----------------
P0

D0 = Divid
p0 = Price at the beginnin
p1 = Price at the end of the year
Measuring Historical Returns

Particulars ABC Ltd. XYZ Ltd.

PO 20 10
P1 15 15
D0 1 1

Return ABC = [1+ (-5)] * 100 = -20%

-----------
20

Return XYZ = [1+ 5] * 100 = 60%

--------
10
Measuring Historical Return of a Portfolio

The return of a portfolio is a simple extension from a

single investment to a portfolio which can be calculated
as the weighted average of returns of each investment
in the portfolio, and it is represented as below,

Historical return = (w, * ry) + (W, * 1;) + cceeeenees + (WS

A
w,; = weight of each investment in the portfolio

r, = rate of return of each investment in the portfolio

= Notes BM Comments =: LL E

4 " Les A
or BE
Alin l'G :
TE

Arrange Quick
v ; - af Shape Effects

Drawing

BR

l-

orical return = (w, * ry) + (w, *r,) +

Price as on 1st | Price as on 31s Yearly =

April, 2021 March, 2022 Dividend
20 30 2
30 I 40 a0
50 60

sssssscancss
1

Measuring Historical Return of a Portfolio

| Stock | Priceason 1** | Price ason 31st Yearly | a

i | April, 2021 | March, 2022 | ~ Dividend | |

Xx | 20 | 30 | 25

YY | 30 | 40 le

Ez 50 | 60 1 sil |
Historical return = (Ww; * r;) + (Ww, * rp) + ceeenenes +(w, *r.) |

tates) (ks Accessibility. Irrvestigate

Wi = (20/100)=0.2 W?2 =(30/100)= 0.30 W3 = (50/100)= 0.50

ri-[(30-20 +2) /20] *100 = 60% |
r2-[(40-30 + 3) /30 ] *100 = 43.33%

rs-[(60-50 + 5) /50 ] *100 = 30%

BB comment
OR = JC oo]
Measuring Historical Return of a Portfolio

Historical Return = (w, * r,) + (w, * i

={0. 20 * 60) + (0.30 * 43. 33) + (0.50 a 30) g

=12+13+15 | fl
= 40% 1

11
till
Lc

Historical Return = Annual return + Appreciation in Portfolio Vz a

| Initial Portfolio i - |

| Ld i i |
2,
»

- | (

= | Measuring Historical Return of a Portfolio

= | | Stock Price ason 1® | Price as on 31* Yearly

= | April, 2021 March, 2022 Dividend

or | = 20 30 | 2

= | 30 a 3
7 50 Tig 5
Portfolio 100 ae 10

: Historical Return = Annual return + Appreciation in Portfolio Value

Initial Portfolio

Historical return = (10 + 30) *¥100 =40 %

100

= Notes El comments 1

aa QQ, Search | oO - 2 ¢ ~~ Ee ®
- Measuring Expected Return

= 1

= The formula of expected return for an Investment with

various probable returns can be calculated as a weighted

average of all possible returns which is represented as

below,

== Expected return = (p, * ry) + (p, *r,) + cco +(p, *r,)

p = Probability of each return

= r. = Rate of return with different probability.

= re —F

12:25 PM

ENG
InN @ wn = 1115/2023 L
LE A OR g 5

fea or RE ET
| A flim wd A

lille
I ~| Arrange Quix
INIA } vi y v tyles 2 shape Efe

Drawing

Probability
0.25
0.50
0.25
Measuring Expected Return of a Portfolio

Consider a portfolio of two securities with 50% investment

in A aad 50% investment in B. The characteristics of returns
under three different scenarios with different probabilities
for the two securities and the portfolio are as follows:

Scenario

Probability

Return %
(A)

Return % E
(B)

0.25

40

0.50

30

1
2
3

0.25

20

—— — i er re ETT ERE TPT EH

0
o Expected Return of a portfolio

n be calculated as

Measurin

d return of a portfolio ca

the weighted average of expected returns of each

the portfolio, and itis represented as below,

investment in
Expected return = (w, * Erg) + (Wy * Erp) + ceueemseense + (W,
Er.)
. w, = weight of each investment in

Er, = Expectedrate of return of eac

portfolio

1
The expecte

the portfolio
h investment in the
raragiapii

Meaning of Risk |

« “Possibility or probability of an investment resulting i

an outcome different from the anticipated outc

« Risk is defined as the volatility of returns.

= + 13

EEE Gt Access ibility: In

“ Q Search AA ki Oo -

ont

Business Risk 1]
Business risk is the risk associated with running a business. The !
risk can be higher or lower from time to time. But it will be i
there as long as you run a business or want to operate and Bi
expand I }
* Poor Business Performance :

i
* Increase in Competition {

-* Emergence of New Technology

* Development of Substitute Products

» Shifts in Consumer preferences |

* Changes in government policies

Interest Rate Risk

* Interest rate risk is the potential for investment losses that

triggered by a move upward in the prevailing rates for new de
instruments.

* If interest rate increases, market price of fixed income securities falls

and vice-versa.

* A debenture that has a face value of Rs. 100 and a fixed coupon rat

of 12% will sell at a discount if interest rate increases from 1 0

% 14%. | {

= Notes Display Settings Ml Comments

LQ Search PET 0 =
Market Risk

* Market risk is the risk that an investor faces due to the

decrease in the market value of a financial product
arising out of the fagtors that affect the whole market
and is not limited to a particular economic commodity.

= * Systematic risk

- * Driven by sentiments in the market

* Causes — optimism, pessimism, movement of Flls, etc.

Inflation Risk

power of the

« Inflation risk is the risk that the purchasin

be reduced by increasing

investment returns will

inflation. Rising inflation that causes an increase in prices
effectively lowers the real return of a given investment.

« Inflation risk impacts investor's portfolio planning,

ards to retirement spending. The higher

especially in re n :
the inflation, the less purchasing ability a retiree will

have when living on their investments.

« Ex: Fixed income Assets, Bonds

Bl comments = BIE

— Notes I Display Settings

gu oucreonuil@ od 0

Ru Bm QQ search id

EE —
Portfolio Risk

Portfolio Risk is measured by calculating the standard deviation

of the portfolio. Standard deviation alone cannot calculate the

portfolio risk. There is a need to ensure that all the different

standard deviations are accounted for with their weights and the

existing covariance and correlation between the existing assets. In

this regard, covariance can be defined as the extent to which stocks

move in the same direction.

es) &) Accessibility: Investigate

\
ai :
Q searct
Search
a _
Portfolio Risk

« Using these three variables. the following formula 1s

used to calculate portfolio risk:

Weight of Asset A) A2 * (SD

ht of Asset B)*2 * (SD of
f Asset A*Weight of Asset
Asset A and Asset B *SD

Portfolio Risk = Sqrt |(

of Asset A) "2) + (Weig
Asset B)"2) + 2(Weight 0
B*Correlation between
Asset A * SD Asset B)|
Two-Stock Portfolios k
Two stocks can be combined to form a
riskless portfolio if p = -1.0.

Risk is not reduced at all if the two

stocks have p = +1.0.

In general, stocks have p ~ 0.65, so

risk is lowered but not eliminated.

Investors typically hold many stocks.

What would happen to the
‘risk of an average 1-stock
portfolio as more randomly
selected stocks were added?

G, would decrease because the

added stocks would not be

perfectly correlated, but r, would
remain relatively constant.
Prob.

Paragraph

by Ly? 0g i a) v — - (7g)
a Arrange '
1 ly 1 ot tir - ah
Drawing
Large

= Noles

Return

8 comments

© @ ~~ <
Cp (%)

35

Paragraph

Company Specific
(Diversifiable) Risk

Stand-Alone Risk, Cp

20

Market Risk

10 20 30 40 2,000+

# Stocks in Portfolio

=! Comme

o0®s

SW CR = A ON ~
Market / Systematic Risk

* Market risk ‘is that part of a security’s stand-

alone risk that cannot be eliminated by

diversification because it depends on the factors

affecting the whole market in a particular

direction.
Unsystematic Risk

* Unsystematic risk is the extent

of variability in. the security’s
return due to the specific risk

attached to the firm of that

particular security.
Unsystematic Risk

« Unsystematic risk is diversifiable risk and hence this

risk can be removed from the total risk of portfolio by
investing in large portfolio securities. This is possible,
because the firm-specific risk factors are mostly
random. For example: if the financial position of one

company 1s weak, the financial health of the other

company in the portfolio can be strong enough to

neutralize the risk attributed by the weak financial

position of the firm.
CE —

Market / Systematic Risk

For example: A steep rise in inflation in India

will affect the entire market adversely and
therefore, no diversification can makel a

portfolio free from this risk. Since the

systematic risk affects the entire market, it is

also known as the market risk.
Stock Beta x

#“In addition to measurin

adit g a stocks
contribution of risk to a portfolio, beta
measures the stock’s volatility relative to the

market.
»Beta is also referred to as financial elasticity
or correlated relative volatility. ¥

ure of the sensitivity of the

arket returns and hence
non-diversifiable risk,

ket risk.

7Beta is a meas
asset's returns tom

IS known as
systematic risk or mar
How is beta interpreted?
| DELETE ed

If b = 1.0, stock has average risk.

If b> 1.0, stock is riskier than average.

ifb< 1.0, stock is less risky than

average.

Most stocks have betas in the range of

0.5 to 1.5.

© Slide 10 of 34 »)
_How is beta interpreted?

An asset with a beta value “ZERO” means that

its price is not at all correlated with the market
and the asset / stock is independent.

"A positive Beta means that the asset generally

follows the market. iN

= A negative Beta shows that the asset inversely

follows the market. This means that the asset
generally decreases in value if the market goes

up.
TASKBAR £5 DISPLAY SETTINGS ¥ 0B END SLIDE SHOW

‘Geared & Ungeared Beta

« The beta attached to the ordinary shares of a

geared firm is known as geared beta. These
bear a risk higher than the firm's basic activity.

.- An asset beta is sometimes called ungeared or

unlevered beta and can be described as the
beta of equity in a company that Is totally
equity-financed.
How is market risk measured for
individual securities?

* The Beta Coefficient describes how the expected return ofa

stock or portfolio is correlated to the return of the financial

market as a whole.

* It is measured by a stock’s beta coefficient. For stock i, its bet

Is:

bi = Covariance between Security i and market portfolio /

Variance of market
Portfolio Beta

= The beta of a portfolio is the weighted

sum of the individual asset betas.

the proportions of the

in the portfolio. Eg. if

stock A with a

f the money IS
1.00,the

= According 10
investments
50% of the money is in
beta of 2.00, and 50% ©

in stock B with a beta of

portfolio beta is 1.90.

= ww BR ees Ma *T = va

(1

a
vy |

Font i Paragraph

Portfolio Beta

sTock VALUE alli BETA

A 25,000 1.43
B 22,000 0.63
oC 20,000 1.51
D 18,000 0.6
E 9,000 0.42
F 6,000 1.22

1,00,00
un 9Q

Two Security Case (cont'd)

Example

Assume the following statistics for Stock A and Stock B:

Expected return 020

Vanance 060
Standard Beaton |

Weight

Correlation coefficient

© Slide 11 of 36 »)
ANimations stide Show Record Ravigw

Arrange

Paragraph Fave

Two-Security Case

* For a two-security portfolio containing Stock A and Stock B, the

variance is:
Two Security Case (cont'd)

Example (cont'd)

Solution (cont'd): The variance of this two-security portfolio is:

a x,0, * X05 +2X,X, 0,50 Op

(4)* (05) +(.6)°(.06) + 2(.4)(.6)(.5)(.224)(.245)
= 0080 +.0216 +.0132
0428
Introduction

*The reason for portfolio theory

* 10 show why diversification is a good idea

* To show why diversification makes sense

logically
Fie xe Arrange

Font Paragraph BErawing

Introduction (cont'd)

* Harry Markowitz’s efficient portfolios:

* Those portfolios providing the maximum return for their level of risk

* Those portfolios providing the minimum risk for a certain level of retu
—— La dh oN me
A A a oy :

Patagraph

Introduction

Birawing

* A portfolios performance is the result of the performance of its

components

* The return realized on a portfolio is a linear combination of the returns on th

individual investments

* The variance of the portfolio is not a linear combination of component

variances
e what you want to do

Armarige

Crawing

Return

* The expected return of a portfolio is a weighted average of the

expected returns of the components:

ER) => [xERD]

i=l =
where x = proportion of portfolio

invested mn security 7 and

hes = |
i=]
Arrange

Introduction

» Understanding portfolio variance is the essence of understanding the

mathematics of diversification

* The variance of a linear combination of random variables is not a weighted

average of the component variances
S abe A.A y - vv NV
& {Fly ic

Font p
aragraph
grap Drawing

Introduction (cont'd)

« For an n-security portfolio, the portfolio variance is:

! Fa Ei SELES
1 j=l

where x — proportion of total investment in Security #

p. = correlation coefficient between

Security i and Security j

Arr arige
Fam

Two-Security Case

* Fora two-security portfolio containing Stock A

and Stock B, the

variance is:
Paragraph

Minimum Variance
Portfolio (contd)

* For a two-security minimum variance portfolio, the proportions

invested in stocks A and B are:
Paragraph Drawing

Minimum Variance
Portfolio (cont'd)

Example (cont'd)

Solution: The weights of the minimum variance portfolios in the previous cas

06—(.224)(.245)(. 5)

05+.06-2(.224). 245)(.5)

x,=1-.5907 =40.93%
Paragraph

Minimum Variance
Portfolio (cont'd)

Example (cont’d)

1.2 etl ALL

1
0.8
0.6 |
eo |
|
L 0.4 1
~=
Bf 02 sssssscssssssssnsnnnnnanmnnnnps
|
)
Pp, Nii T 1 : er |
om 0 0.01 002 003 004 005 006 =

Portfolio Variance

=n

Ae DE2e66ul

+ 8
Ammange

Paragraph Drawing

Correlation and
Risk Reduction

* Portfolio risk decreases as the correlation coefficient in the returns of

two securities decreases

* Risk reduction is greatest when the securities are perfectly negatively

correlated

* |f the securities are perfectly positively correlated, there is no risk

reduction
Ql

CASE STUDY

[Tigh Low

Stagnation Recession
growth | growth

w | Probability 0.4 0.2 0.3 0.1

Return on ABC stock | | 50 [ 30) 90) 60)
Return on XYZ stock 100 [10 120 140)

Calculate the expected return and standard deviation of investing

(a) Rs. 100 in ABC limited

(b) Rs. 100 in XYZ limited

(¢) Rs 500 in each ABC and XYZ

Given, both the stocks are currently selling for Rs. 10 per share
Practice Problem #1

* If the risk-free rate equals 4% and a stock with

a beta of 0.75 has an expected return of 10%,
what 1s the expected return on the market
portfolio?
Practice Problem #2

* A particular asset has a beta of 1.2 and an

expected return of 10%. Given that the
expected return on the market portfolio 1s 13%
and the risk-free rate 1s 5%, the stock 1s:

A. appropriately priced
B. underpriced
C. overpriced
Practice Problem #3

Last year...

* Firm A: return: 10%, beta: 0.8

* Firm B: return: 11%, beta: 1.0
* Firm C: return: 12%, beta: 1.2

* Given that the risk-free rate was 3% and

market return was 11%, which firm had the
best performance?
The Capital Asset Pricing Model
(CAPM)

* The capital asset pricing model (CAPM) is the basic

theory that links risk and return for all assets.

* CAPM quantifies the relationship between risk and

return.

* In other words, it measures how much additional return

an investor should expect from taking a little extra risk.

The CAPM: Types of Risk

Total risk is the combination of a security’s non-diversifiable risk and

diversifiable risk.

Diversifiable risk is the portion of an asset's risk that is attributable

to firm-specific, random causes; can be eliminated through
diversification. Also called unsystematic risk.

Non diversifiable risk is the relevant portion of an asset's risk

attributable to market factors that affect all firms; cannot be
eliminated through diversification. Also called systematic risk.

Because any investor can create a portfolio of assets that will

eliminate virtually all diversifiable risk, the only relevant risk is non-
diversifiable risk.
Risk Reduction

| FIGURE 6.7 | -
Portfolio risk and e
diversification af
o
3
Fd
] "10 15 20 25
E Number of Securities (Assets) in Portfolio y
E - _——
li YE *
Pe CAPYFAL ASSET

Fo PRICING MODE
AFEFARRI g

It is the equilibrium model that underlies all modern

financial theory.

Ke = RF + (Rm-Rp)x B
= = : x JR
Cost of Risk Fi i

Foeaiee = — ( reco ) X Beta

Assumptions

* Investors are risk averse.

* Investors can borrow and lend freely at a risk free rate of return.
* Single-period investment horizon.

* Investments are limited to traded financial assets.

* No taxes and transaction costs.

* Information is costless and available to all investors.

* Investors are rational mean-variance optimizers.

* There are homogeneous expectations.

Economists

* The CAPM was introduced by Treynor ,Sharpe, Lintner and

Mossin independently, building on the earlier work of Harry
Markowitz on diversification and modern portfolio theory.

Sharpe, Markowitz and Merton Miller jointly received the 1990

Nobel Memorial Prize in Economics for this contribution to the
field of financial economics.

11 O <
What is ‘Beta’?

‘Beta’ is one of the most important concepts

that you need to understand while trying to
learn about stocks and investments.

‘Beta’ is an important indicator of how susceptible

a stock is to movements of the market.

Therefore, ‘Beta’ indicates the sensitivity

of a stock to movements in
the overall market.

Interpreting Beta

The following are some important points that you should bear in mind while
interpreting ‘Beta’:

ar, -_—-— yy -— i

—_——

| | : I
If Beta = 1.0 = This 1 | If Beta > 1.0 = This " | If Beta < 1.0 = This 1
| means that the | 1 means that the { 1 means that the ’
| stock has the same { ; stock has more risk : : stock has less risk .
| risk asthe market. 1 | thanthe market. | | thanthe market. |
| Therefore, astock | 1 Therefore, astock | 1 Therefore, astock |
| withBeta=1will | | withBeta>1.0will : | with Beta < 1.0 :
I move with the 1 | movemorethan 1 | will move less i]
| market. ; | the market. } | than the market. }
1

-—

mm wm mw wm wm
What is ‘Beta’?

‘Beta’ is one of the most important concepts

that you need to understand while trying to

learn about stocks and investments.

indicator of how susceptible

‘Beta’ is an important
8 market.

a stock is to movements of the

Therefore, ‘Beta’ indicates the sensitivity

of a stock to movements in
the overall market.

The following are some important points that you should bear in mind while
interpreting ‘Beta’:

I
1
&
|]

- =m

-—

If Beta < 1.0 = This |

If Beta=1.0=This If Beta > 1.0 =This

: i P|

i 1 : 1

| means that the | 1 means that the : I means that the :

; stock has the same | | stock has more risk y | stock has less risk !
t risk as the market. | than the market. | than the market.
| Therefore, astock | 1 Therefore, astock | 1 Therefore, a stock |
| withBeta=1will | | withBeta>1.0will ! | with Beta < 1.0 !
I move with the I | movemorethan | | will move less 1
| market. h | the market. ! | than the market. 3
ES I 1 1

CAPM

The CAPM can be divided into two parts:

1. The risk-free rate of return, (R;) which is the required

return on a risk-free asset, typically a 3-month Treasury

bill.

2. The risk premium.

* The (r,, — Ry) portion of the risk premium is called the market
risk premium, because it represents the premium the investor
must receive for taking the average amount of risk associated
with holding the market portfolio of assets.

|] O <
The CAPM - SML

* The security market line (SML) 1s the depiction of the

capital asset pricing model (CAPM) as a graph that
reflects the required return in the marketplace for each
level of nondiversifiable risk (beta).

* It reflects the required return in the marketplace for each

level of non-diversifiable risk (beta).

Security Market Line

Security Market Line

Security market line (SML)
with Benjamin Corporation's
asset Z data shown

Tm =

Required Return, r (%)

r-

Nondiversifiable Risk, b

In the graph, risk as measured by beta, b, is plotted on the

x axis, and required returns, r, are plotted on the y axis.
* Rule
the Ia
hargai
value
* Rule J
like th

Valuation of Securities

«Most investors look at price movements in

securities markets. They perceive opportunities
of capital gains in such movements. All would
wish if they could successfully predict them and
ensure their gains. Few, however, recognize that
value determines price and both changes

randomly. It would be useful for an intelligent

investor to be aware of this process.

nchvant
later mx
* Rule JX:
stale wi
expecte
Investment Rules

e Rule 1: Buy when value is more than price. This underlines

the fact that shares are underpriced and it would be a
bargain to buy now and sell when prices move up toward
value.

«Rule 2: Sell when value is less than price. In a situation

like this. shares would be overpriced and if would be
advantageous to sell them now and avoid less when price

later moves down to the level of the value.

«Rule 3: Don't trade when value is equal to price. This 1s a
state when the market price is in equilibrium and 1s not

expected to change.
The Basic Valuation Model

Value of an asset is equal to present value of its expected returns.

This is true particularly when you expect that the asset you own,
provides a stream of returns during the period of time. To covert
this estimated stream of return to value a security, you must
discount the stream of cash flows at your required rate of return.
This process of estimation of value requires i

(a) the estimated stream of expected cash flows and

(b) the required rate of return on the investment. The required rate
of return varies from security to security on account of
differences in risk level associated with securities.
The Basic Valuation Model

Given a risk-adjusted discount rate and the future expected

earnings flow of a security in the form of interest, dividend

earnings. or cash flow, you can always determine the present value
as follows:

CF. CE, CE;

== 424 ,
{+r (141) (FE)

PV

PV = Present value

CF = Cash flow, interest, dividend. or earnings per time period

upto ‘n' number 0 f periods.

r = risk-adjusted discount rate (generally the interest rate)

n o

There are many practical challenges with this model.

For instance, it may be quite difficult to assume that

every investor in the market exactly measure the value
of cash flows and risk adjusted required rate of return.
Further, investors' expectation on compensation for risk

may also different between different types of investors.

A small change in these measures will also cause a

change in the value. Thus, it may not be possible to

generate a single value.
Secondly, return, risk, and value would tend to change over

time. Thus, security prices may rise Of (all with buying and
respectively (assuming supply of securities
(fect capital gains and hence
estimates of future Income

selling pressures
does not change) and this may «
returns expected. Consequently,
to be revised and values rewol ke

Similarly, the risk complexion of the se urity may f hange ovel

rhe firm may over borrow or engage in a risky venture,
An increase in risk would raise the discount rate and lower
value. Every new information will affect values and the buying
and selling pressures, which keep prices in continuous motion,
ve them continuously ( lose to new values

will have

ime.

would dri

EEE
Valuation of Securities

*Balance Sheet Valuation

*Dividend Discount Models

Earnings Multiplier Approach

(© Slide 26 of 35 >)
Balance Sheet Valuation

«Book Value Method

eLiquidation Value
Book Value Method

«Book Value = (Net Worth of the Company)

No. of Equity Shares

Where
Net wort

h = Paid-up Equity Capital + Reserves & Surplus

Book Value Method (contd.)

« ABC Ltd. net worth is Rs. 36 lakhs and the number of

outstanding equity shares is 2 lakhs.

Book Value = 36 / 2 = Rs. 18 per share.

eBook Value method is based on accounting

conventions and policies

«There is lot of subjectivity and arbitrariness in this

method. ‘
Liquidation Value Method
* Liquidation Value

= (Value realized from liquidating all assets of the firm

— amount to be paid to all creditors & preference

Shareholders) L
No. of Equity Shares

Where
Net worth = Paid-up Equity Capital + Reserves & Surplus
Liquidation Value Method - Limitations

o|t is difficult to estimate realizatior

value.

-Liquidation Value does not reflect

earning capacity.
pox?
nur) )
2d 5

Jory IN| d rep

2,

-
cs
~ a be
H Mode]

PO = DO[ (1 +gn) +H (ga — gn)

(r—gn)
Where,

Po = Intrinsic Value of the share

DO = current dividend per share

r= Investor's required rate of return

EN = normal long run growth rate

Ba = current above normal growth rate

H = one half of the period during which ga will level off to gn

Dividend Discount Models of Valuation

» Zero Growth rate Model

* Constant Growth Rate Model
* H Model

= Naa) Comments
Zero Growth Model

PO=D/r

Where,

Po = Intrinsic Value of the share

D = current dividend
r= Investor's required rate of return
fe eT ETT al FETE FEN EH iad Ae

Animations ~~ SlideShow Record Review View Help ¢ Tell me what you want to do

Constant Growth Model (Gordon Model)

PO=D1/(r-g)

Where,

Po = Intrinsic Value of the share

D1 = expected dividend

r= Investor's required rate of return

g = Constant Growth Rate
Parag aph Drawing

H Model

PO = DO[ (1 + gn) + DOH (ga —gn)

(r—gn) (r—gn)

= Value based on normal growth rate + Premium due to abnormal

growth rate
« The Current Dividend on an equity share is Rs. 3. The present

growth rate is 50%. However this will decline linearly over a

period of 10 years and then stabilize at 12%. What is the

intrinsic value per share if investors require a return of 16%.

The P/E Approach to Equity Valuation

The PIE approach is fairly simple and widely followed in the

stock market. The first step under this model is estimating

= future earnings per share. Next, the normal price-earnings

ratio will be found. Product of these two estimates will give
the expected price. The most practical way of using PIE

model is first computing the industry average P/E or PIE of

similar firm and then multiplying the same with the expected

or actual earning of the stock.

The P/E Approach to Equity Valuation

*P/E of an industry is expected to be high

when the industry is in high growth
industry. P/E will be low if the industry or
firm is expected to show a low growth rate.

PIE is also affected by the risk associated

with the earnings.
Sales Growth, Net Profit Growth and P/E Ratio of Large Indian Companies

Company Name Sales Growth | NP Growth

Zee Telefilms Ltd. 3% T%

Infosys Technologies Ltd. 86% 09%

Hindustan Lever Lid. 28% 41%

Larsen & Toubro Lid. 13% 2%

Reliance Industries Ltd. 30% 16%

Bajaj Auto Ltd. 6% -3%

Bharat Heavy Electricals Ltd. 7% 5%

Tata Iron & Steel Co. Lid. 4% 4%

13% 11% 7.05

-5.96

Hindalco Industries

Tata Engineering & Locomotive Co. Ltd. 3% -181%

Note: Sales and Net Profit Growth values are average growth values of five years
(1997-2001)

J Ts) Gs Accessibility: Investigate = Notes =] POSER

ali Q Search Jos B kL 2 pr @ ~® y | J

Er —
WB fairl = le DD, Gpekd pL kd 4 |

Tynpact of grew ty on Pree Rot trun A Rati. | |

es) vr. Me ) © = 5% A | i
eT
Lopes svat Grout ois TE al |

Yguired yoli Atv = Jo To. 1

Corpute. Fut: Foicel || Rinftecd yleld, byl 4l_Goises
fried 0 WE vale) 1 | gh

B odm a — - a a l
c an nual rates of return of ABC Ltd. And the market rates of | et In

Return of ABC Ltd. (%)

-8

Ss

17
Characteristics of Bonds

*Bonds . debt securities that pay a rate 0

| nterest based upon the face amount or par

value of the bond. 3

rice anes: as market interest changes pe

- payments are commonly semi-a

lle | investors receive full face amc

S mature !

l (SH II hl idl lA ul
” | ’ aa i IRA

my | Wy eA
a
* Government vs Corporate Bonds

5a = Callable (can be called before maturity) and Non-Callable bonds

* Convertible Bonds (Can be converted into equity either full or

partially)

- D coupon / Deep Discount / No discount bonds — no per

payment (no interest reinvestment rate) Originally sold at a di

* The return received from a zero coupon bond or a pure discot

Eee on an annualized basis is the spot interest rate.

e spot interest rate is the discount rate that makes the Pv of |

flow to the investor equal to the cost of the hom
al

Bond Returns | 3

. Coupon Rate is the nominal rate of interest fixed and printed ¢ on

bond certificate.

* Current Yield = (Annual Interest / PO) * 100

* When bond is selling at a discount

* Current Yield > Coupon Rate

» When bond is selling at a premium

* Current Yield < Coupon Rate
SPOT INTEREST RATE

*PO = CF: / (1+k)

* Example: FV = 1000; PO = 797.19, Duration = 2 years

2
797.19 = 1000 / (1+k)

= Notes 8 comments
Yield to Maturity

~ *YTM is the compounded rate of return ar

investor is expected to receive from a bona

purchased at the current market price and

E held to maturity. It is really the Internal Rate
Terminal Value Method
7

vl _ C+ y ry

BY THs (1 Y700)"
EV , 0D Cowppn Roly = 157,
ais = fe. 00 N= S

Try 20%
[geo = io Lb loeD
+e (1+ Yt) (1+ yrh)>

= Wes + Yol+%o

~ AEN Te aA A Neri Melis ro

Valin at (bres - Value i La (20
Z
di od [4k foes 9
$< 61

0 X PvE Fa ul,
Je (£45,209) ecu)
Co ND. q9t J&P XD .YpI9

esp. 49
C. = (uvedd maka price
n — holduy pated He pakuai?y.

TV TM = 1o+ [oo — qe0)/s

[Lee + 96mm
PEL AN
p A ceil fo. 3-100
| 950 L ai lee F&
’ a Be 1A Lenni 29%