FIN Exam 3

Using Beta to Determine Expected Returns

What is a risk premium? -> The amount by which an investment is expected to outperform T-Bills (risk free assets) -The Market has averaged 12% a year -T-Bills have averaged 4% a year -The market risk premium is 8% (12 - 4 = 8%)

Where to Get Info for Valuation?

Two principal sources on Internet: 1.) The best source for cash flow inputs is the investor relations link of the company's own Web site (annual audit and earnings and press releases). Info on revenue, NOPM, investment rate, working capital, historic growth. 2.) Yahoo! Finance, or MSN Money. Gives stock price, beta, shares outstanding, projected growth rates, interest rates.

Market Efficiency on a graph

-Before the fact and using expected returns based on beta, if a market is efficient, all investments lie on the risk-expected return line (one investment is as good as another) -After the fact, using average/observed returns based on beta, some firms have positive and some have negative alphas (below or above the risk line) -With expected return, if firms plotted off the line, those plotted above the risk line are undervalued (too high and people will buy) and those plotted below the risk line are overvalued (people will sell it)

Alpha Applied to Mutual Funds

-Gross Return means "before expenses" (can only distribute a net return to shareholders) Net Return = Gross Return - Expenses Ex: For XYZ, gross return = 11.4% and expense ratio is 1.2% (about average for stock funds). What is XYZ's net return? -> Net Return = 11.4% - 1.2% = 10.2%

Management of Risk: Diversifying, Hedging, Insuring and Derivative Securities

-In life, we are exposed to risk (car crash, being sued, losing your job, quitting a job, owning assets, etc.) -Can purchase insurance to protect from risk -If interest rates go down, payoff profile would go up

The Yield Curve, Inflation and Deflation

-Inflation: The average increase in price levels over time (averaging about 1-3% per year) -Deflation: A period of gradually declining prices -Nominal Interest Rate: The actual rate of return or yield associated with an investment (not adjusting for the effect of inflation or deflation) -The Real Rate of Interest: The difference between the nominal rate of interest and the rate of inflation Formula = (Nominal/Observed - Inflation Rate) Example: If inflation is 2% and nominal interest rate of 10 year Treasury bond is 6%, then: Real Rate of Interest = 6% - 2% = 4%

Interest Rate Risk

-Interest rate risk is the most difficult risk to assess -The price volatility of a bond is the extent to which its price changes with fluctuations in market levels of interest rates -Bond prices and yields move in opposite directions, other things being equal. The magnitude of price movements will differ based on specific bond characteristics -Interest rates go up, bond prices go down *The longer the maturity of a bond, the higher the volatility of bond prices, the greater the risk* -> The table below gives the price change for a 1% increase in yield: Maturity Coupon Yield Price % Change 10 6% 7% $92.89 -7.11% 20 6% 7% $89.32 -10.68% 30 6% 7% $87.53 -12.47% *The lower the coupon on a bond, the higher the price volatility, the greater the risk* -Zero coupon bonds have extreme price volatility! -> The table below gives the price change for a 1% increase in yield (assume a 30 year maturity): Coupon Yield Price Yield Price % Change 0% 6% $16.97 7% $12.69 -25.23% 6% 6% $100 7% $87.53 -12.47% 12% 6% $183.02 7% $162.36 -11.29%

Mental Accounting

-Investors taking big risks in one area and avoiding rational risk in another area (affects risk taking behavior) -People often do not focus on their overall state of wealth. -Segregate money into separate mental accounts; people deposit money into their different accounts... 1. Retirement (401(k), IRA, etc.) 2. Children's education 3. Taxable investment accounts 4. Dividends 5. Company stock or stock options -Inclination to treat money differently depending on where it comes from, where it is kept, or how it is spent. -Segregate money into separate mental accounts; people deposit money into: 1. Saving money (risk aversive) vs. Spending Money 2. Sacred inheritance (being conservative, practicing loss aversion) 3. Paper money

Market Segmentation Hypothesis

-Market Segmentation Hypothesis/Preferred Habitat Hypothesis=Recognizes that the market is composed of diverse investors who have different preferred habitats i.e. short term and long term investments for the investment requirements -To induce investors to move away from their preferred position on the yield curve, an issuer must pay a premium. Thus any maturities that do not have a balance of supply and demand will sell at a premium or discount to their expected yields and the shape of the yield curve is dependent upon demand and supply -A function of supply and demand for short-term versus long-term bonds -Different investors prefer different investment securities

Residual Value or Salvage Value

-Once a company loses its competitive advantage the stock price of the company still grows in value, but its growth does not exceed its risk-adjusted market expectation of the investors. -At that point in time, the after-tax earnings of the company can be treated and valued as what is known as a cash flow perpetuity—equal to the company's net operating profit after tax divided by its WACC. This discounted value is called the company's residual value. *Residual value is very important—it generally represents 60% to 90% of the company's stock value*

Duration Gap Analysis

-Owners and managers care about the impact of interest rate exposure on current net income. They are also interested in the impact of interest rate changes on the market value of balance sheet items and the impact on net worth. -The concept of duration plays a role here. -Duration Gap Analysis: Measures the sensitivity of a bank's current year net income to changes in interest rate. -Requires determining the duration for assets and liabilities, items whose market value will change as interest rates change. Let's see how this looks for First National Bank. The basic equation for determining the change in market value for assets or liabilities is: % Change in Value = - DUR x [Δi / (1 + i)] or Change in Value = - DUR x [Δi / (1 + i)] x Original Value Ex: Consider a change in rates from 10% to 15%. Using the value from Table 1, we see: Assets: Change in Asset Value = -2.7 x .05/(1 + .10) x $100m = -$12.3m Liabilities: Change in Liability Value = -1.03 x .05/(1 + .10) x $95m = -$4.5m Net Worth: ΔNW = ΔAssets - ΔLiabilities ΔNW = -$12.3m - (-$4.5m) = -$7.8m -For a rate change from 10% to 15%, the net worth of First National Bank will fall, changing by -$7.8m. -Recall from the balance sheet that First National Bank has "Bank capital" totaling $5m. Following such a dramatic change in rate, the capital would fall to -$2.8m.

Prepayment Risk

-Prepayment risk is the risk that a bond will be retired or redeemed at a time earlier than its maturity date. -The call options and redemption features in debt instruments introduce uncertainty into the expected cash flows. This uncertainty has a cost, in the way of a higher rate of interest on the bonds *Callable bonds have higher yields than non-callable bonds because of the value of the call option (valuable to the bond issuer)*

Return on Stockholders

-Return to stockholders includes any dividend payments plus the increase (or minus the decrease) in stock price that investors experience during an investment holding period *Dividends are paid 4 times a year, so if it were quarterly, dividends are multiplied by 4!* Formula: % Return = (Dividends + Change in Stock Price) / Beginning Stock Price EX: A stock's price started the year at $100, the stock paid $1 in dividends during the year, and it ended the year at $109, its percentage annual return to stockholders equals: ($1 + $9) / $100 = 10%

The Management of Risk

-Risk is usually measured by the volatility of the rate of return, such as standard deviation -Trade off between risk and return: The higher the return, the higher the risk -Stocks and bonds are risky securities (bonds are less risky than stocks) *High standard deviations show high risk* -Interest rates can rise and fall (as interest rates go up, bond and stock prices go down) -Companies can miss earnings target causing stock price to decrease -Rational investors are usually risk averse! -Ways to reduce risk associated with financial assets: 1. Diversification (Spread the risk by investing in a number of risky assets) 2. Hedging (By using techniques to lock-in a price or return) 3. Insurance (Pay a premium to purchase a contract to protect) 4. Sell the assets (if market is too volatile)

Investor Expectations Regarding Stock Market Returns

-S&P 500 50-year returns: 1946-96, S&P 500 7.13% real average yearly return vs. 6.96% EPS/price median earnings yield -Long run-real stock returns (after inflation) closely track real growth in earnings -Short run-interest rates and risk are important influences on stock price.

Technical Analysis

-Technical analysts believe that stock prices are influenced more by investor psychology and emotions of the crowd than by changes in the fundamentals of the company (supply and demand) -Technical analysts chart historic stock price movements, volume of trading activity, and the price/volume aspects of related equity and debt markets to predict or anticipate the stock buying behavior of other market participants. -Technical analysts generally have a shorter-term stock holding orientation and more frequent trading activity (day traders) -Incorporates behavioral finance Ex: Look at charts for different companies to look at past prices and volumes to predict future stock levels

Valuepro.net Online Stock Valuation Web Site

-The Web site www.valuepro.net is devoted to the DCF method of stock valuation and has links that explain the approach in detail. -Type a stock symbol into the slot on the home Web page, click on the Get Baseline Valuation button, and the online valuation program accesses data sources for information relating to the company that you are valuing and calculates twenty variables, puts them into a valuation algorithm and calculates the intrinsic stock value of the company using a simple discounted cash flow model. -You can go to any or all of the input cells, put your own estimates into the cells, hit the Recalculate button, and the online valuation program calculates the new intrinsic stock value based on the inputs that you have provided -If you want to see the detailed pro forma statement associated with the valuation, click on the Cash Flows button and a cash flow schedule based on the underlying inputs appears

Simple Averages of Percentages are Never Simple

-The math underlying investment returns and percentages computes investment gains more favorably than comparable losses. Ex: Invest a $100 investment today that grows to 20% to $120, so you let it rise the next year. But it drops by 20% from $120 to $96. Year 1 you gained 20%, but year 2 had a 20% loss making your average investment 0. -Problem is embedded in calculation of simple averages. If there is a negative percentage return the calculation of a simple average is biased upwards. -Simple average returns can hide very poor performance. -Fallacy makes it harder than it seems -Want to look at compound average return for more accuracy

Is Microsoft worth it?

-The recent stock market crash was due to an increase in systematic risk in the marketplace Is Microsoft worth $311.8 billion? -> Probably

Isn't there more to Risk than Beta?

-Yes. Unsystematic or firm specific risk (risk that affects the return of that firm or industry only) -On average, the firm specific risks average out to be zero, if an investor holds a diversified portfolio. -Finance/Modern portfolio theory assumes that investors are rational and own diversified portfolios.

Errors of Preference (Changes Versus States and Outcomes)

Can have an equally likely outcome and the concern is not losing (take the sure thing rather than gamble on a loss) Ex: You are Richer by $20,000 and You Face A Choice Between: A. Receive $5,000; or B. Receive a 50% Chance to Win $10,000 and a 50% Chance of $0 Loss Aversion (investors expect high returns while taking low levels of risk) Ex: You are Richer by $30,000 and You Face A Choice Between: A. Lose $5,000; or B. A 50% Chance to Lose $10,000 and a 50% Chance to Lose $0 *Will always pick the guaranteed amount (lose the money) You are Offered a Bet on a Coin Toss. If You Lose, it Costs You $100. What is the Minimal Gain That Would Make This Bet Acceptable? A. $75 B. $100 C. $225 D. $350 Answer -> $225 (Prospect Theory=Investors overweight the negative feeling of a loss compared to an equal percentage gain) *Loss is more painful than the joy of a gain (loss has about 2 ½ times the impact of a gain of the same magnitude)*

Diversification (the costless way to reduce risk)

Diversification=To spread your wealth equally over different investments. -As long as the returns of assets are not perfectly correlated, diversification acts to reduce risk *Invest in assets that give you the highest return possible for a given level of risk (Investing on the Efficient Frontier) -Correlation: a) Measures the degree to which the movement of variables are related, and can range between -1.0 to 1.0 b) Correlation of 1.0 means when one stock up 10%, the other stock also up 10% (high correlation) c) Correlation of -1.0 means when one stock up 10%, the other stock down 10% (uncorrelated) d) Assets that are highly correlated offer less risk reduction *Want a correlation close to zero or negative (if possible like gold)* -Stockholders face two types of risk: Systematic risk and Unsystematic risk Formula: Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk: -Represents the risk of the stock market -It is caused by economy, taxes, and other market factors -It can NOT be diversified away! (war, changes in rates of inflation, credit crash) Unsystematic Risk: -Is specific to a company (management or accounting issue, SEC investigation, lawsuit) -Diversification reduces the unsystematic risk -Can be diversified away! -Diversification is easy to obtain in a portfolio (change the risk with the return) -Achieving the highest return for certain level of risk is known as investing on the efficient frontier -Studies show that 20—25 stocks are sufficient to reduce risk and price volatility -The average rate of return for the portfolio would be the rate of return from the average stock

Hedging (sacrifice gain to protect against loss)

Hedging: Reduces or offsets the exposure to the price movement of an asset. *When you hedge, you give up the possibility for a gain in exchange for reducing the risk of a loss* Ex: Farmers that grow soybeans or corn, try to reduce price risk by entering into contracts to deliver the crops at a price that is determined today (hedge) There are three types of hedging instruments: 1.) Future contracts -A forward contract with standardized terms that trades on an organized exchange (Treasury Bond contracts, S&P 500 future contracts, Chicago Board of trade) 2.) Forward contracts -A written agreement between two counter-parties that is not traded on an organized exchange (less liquid) 3.) Swap Contracts -An agreement between two or more parties to exchange sets of cash flows over a period of time -Interest swap and currency swap (credit default swaps) *All contracts are agreements to deliver a commodity at a certain date in the future at a price set today* Some terms relating to hedging: -Hedgers (fix selling price of asset) and speculators -Long position and short position -Value and size of a contract -Spot price and forward price *When an investor hedges, he fixes the sales price for the asset and gives up any upside gain for offloading the risk of loss.

Heuristics and Behavioral Biases

Heuristics (Rule of Thumb, Educated Guess, or Common Sense)=Experienced-based techniques for problem solving and learning (a belief) -Investors decisions are influenced by how a problem is presented ("framing") -Investors like to live in the past (use a few past trends to predict the future which is not always a guarantee) Ex: Price-Volume graphs of technical analysis to predict future stock prices -Herding=Copying behavior of others for no good reason (go with the crowd). We believe a majority of investors cannot be wrong, so we follow along. Creates investors to buy high and sell low, but you want to do the opposite of that! -People tend to be overconfident and optimistic (believe good things happen to them, bad things happen to others). Fool Theory=Optimistic investors buy overvalued stock to sell to greater fools at higher prices.

Income Gap Analysis

Income Gap Analysis: Measures the sensitivity of a bank's current year net income to changes in interest rate. -Requires determining which assets and liabilities will have their interest rate change as market interest rates change. Let's see how that works for First National Bank.... Assets: -Assets with maturity less than one year -Variable-rate mortgages -Short-term commercial loans -Portion of fixed-rate mortgages (say 20%) Liabilities: -money market deposits -variable-rate CDs -short-term CDs -federal funds -short-term borrowings -portion of checkable deposits (10%) -portion of savings (20%) If RSL > RSA, I increase results in: NIM decrease, Income decrease GAP = RSA - RSL = $32.0m - $49.5m = -$17.5m Income = GAP x I = -$17.5m x 5% = -$0.9m *This is essentially a short-term focus on interest-rate risk exposure. A longer-term focus uses duration gap analysis.

Insurance (pay a premium to protect against loss, don't surrender gains)

Insurance Contracts: -Cap-Limitation of the amount of money paid under a claim -Deductibles Option: -Financial assets that have characteristics similar to insurance contracts/policies *Represents the right to sell or purchase an asset at a fixed price at a fixed time in the future* -If asset price at that point in time is advantageous to you, you decide whether to buy or sell -If asset price at that time is NOT advantageous to you, do not decide whether to buy or sell -Have the option to do what you want, are not obligated! Option -Strike price (Also known as exercise price, predetermined; price of which the option on the asset is exercised) -Expiration date (After which the option can no longer be exercised) -Call option (Call option contracts enable the owner to buy an asset) -Put option (Put option contracts enables the owner to sell an asset) *If option can only be exercised on the expiration date, it is a European option. If it can be on any date, it is called an American option* Option where... S = Current market price of security underlying the option Xc = Exercise price or strike price on the call option Xp = Exercise price or strike price on the put option -The call option is in the money if S > Xc -The put option is in the money if S < Xp -An option has positive value to its owner before expiration -The price or value of a call or put option has two components: Intrinsic value and Time value -> Intrinsic Value=The amount the option is in the money and is the difference between the current asset price and the strike price of the option. -> Time value=Reflects expectations of an option's profitability associated with exercising it at some future point in time (excess value of the option / Intrinsic value) Ex: If McDonald's stock is trading at $20 per share and the strike price of an option that expires in six months is $18, and the option is trading at a price of $3.80, the intrinsic value of the option is: Intrinsic Value = S - Xc = $20 - $18 = $2 Time Value of Option = $3.80 - $2 = $1.80

Implications for Investor's Returns

Investor biases lead to... 1. Poor investors/investment choices 2. Stock market bubbles 3. Irrational exuberance 4. Overreactions and underreactions 5. Price momentum *Biases are show to give investors poor investments choices and poor results* *Investors seem to be buying in the up markets and selling in the down markets (irrational)!

Disposition Effect

Investors tend to hold on to losers too long and sell winners too quickly. Regret Theory: The fear of regret leads to loss aversion (emotions affect your buy/sell habits) -Regret is more than the pain of a loss. It is the pain associated with feeling responsible for the loss. *Studies Show Investors Are 50% More Likely to Sell Winners Than Losers

Microsoft's Stock Price: A Mature Growth Company

On 11/25/2013 stock price of $37.35/share, 8.35 Billion shares -Total Market Cap= $311.8 Billion -P/S ratio is 3.9 times sales of $80.4 Billion, P/E is 13.5, Price/Book ratio is 3.85. -Pays $1.12 annual dividend, and actively repurchases shares -Beta = 0.79 Yahoo, Analyst Exp. Growth rate= 7.18% -Microsoft's price got hit hard during the financial crisis, but came back

Derivative Securities (continued)

Types of derivative securities: 1.) Equity and Debt Components: -Embedded with the characteristics of a simple stock or bond. -The bond component can be fixed-rate, zero-coupon, or amortizing (add or subtract option components) 2.) Option or price insurance components: -Interest rate floors and caps, call and put options. -Zero or positive values are associated with these components for the owner of the option. -Zero or negative values are associated with these components for the writer of the option. 3.) Hedging or price-fixing components: -Forward, futures contracts, interest rate and currency swap -The value of these components may be positive or negative, depending on movements and shifts in yields, currency levels, or spot prices. -The relative value at the time of issuance of the derivative security is zero. -Generally have little upfront cost and are the most efficient type of hedging contract. Relationship between cash and derivative markets: -Prices of assets are related (Costs of storage and delivery are associated with futures and forwards) -The concept of arbitrage and the law of one price a) Investors constantly check the cash and derivative market to look for arbitrage opportunities b) The law of one price dictates that the futures price of an asset and the spot price of the asset must be the same on the day future contracts expire Valuation of Derivative Securities: -The value depends upon the value of the underlying simple securities or building blocks! -The value is usually based on following inputs: 1. The spot price and movement of the underlying assets 2. The amount of time to the expiration or delivery date 3. The exercise price 4. The risk free rate of interest 5. For option, the volatility associated with the underlying assets Role of derivative markets: -More liquid than spot markets (Transaction cost is lower and less capital is required) -More efficient than spot market a) Encourage arbitrageurs to participate and drive price to equilibrium b) Invoke the law of one price and does not allow arbitrage opportunities to exist for a long time Can be used to manage risk or to speculate

Sample Averages for Investments

Percentage Risk Premium Treasury Bills 4% - Govt. Bonds 5% 1% Corporate Bonds 6% 2% Avg. Common Stock 12% 8% *Risk Premium is the amount of return you expect to receive on an asset class above the risk free rate Ex: The risk free rate refers to Treasury Bills, so to find risk premiums for other investments, take their percentage minus 4% (percentage for T-Bill) -Govt. Bond is 5 - 4 = 1% and Corporate Bond is 6 - 4 = 2%

Estimate Microsoft's Discounting Rate (Its WACC) -Step 3

Assume the following: -Microsoft has $12.601 Billion debt outstanding -Spread to Treasuries (AAA) = 1.5% -Risk-free 10 Treasury rate = 5.0% -Equity Risk Premium = 4% -Microsoft's beta = 0.79 -Therefore Microsoft's WACC = 8.05% (average of all the numbers)

What is Rate of Return?

Rate of Return = (Final - Initial) + Dividends / Initial Ex: Buy IBM at $90, receive a cash dividend of $4, and sell it one year later at $104 Final = 104, Initial = 90, Dividend = 4 (104-90) + 4 / 90 = 0.2 x 100% = 20% Slide Definition: Rate of Return = Cash Payment +/- Change in Price/Price Paid Ex: Buy IBM at $90, receive a cash dividend of $4, and sell it one year later at $140 -> Rate of Return = ($4 + $104) / ($90) = 0.2 = 20%

Management of Risk (Announcement Definitions)

(1) Managing of Risk-General: (a) Diversification=Costless way to reduce risk. (b) Hedging=Sacrifice gain to protect against loss. (c) Insurance=Reduce risk by paying a premium and sacrificing upside gain. (d) Use Derivative securities to reduce risk. (2) Relationship of 5 asset classes: T bills, T bonds, Corporate Bonds, Large Company stocks, Small Company Stock. Looked at return average and standard deviation of Return. Risk measured by volatility of rate of return. (3) Rational investors are risk averse. To reduce risk you can Diversify, Hedge, Insure. (4) Diversification: The costless way to reduce risk and invest on the efficient frontier. 20-25 stocks sufficient to greatly reduce risk. Correlation among assets are key to reduction. (5) Total Risk: Systematic risk can not be diversified away: taxes, war, terrorist attack, Pandemic. Unsystematic risk-specific to a company, SEC investigation, Dept. of Justice investigation. This can be diversified away. (6) Hedging: Reduce risk to protect against loss. (a) Futures Contracts- with standardized terms that trade on an exchange. (b) Forward Contracts- agreement between two parties not traded on exchange. (c) Swaps- exchange cash flows over a period of time. (7) Options: The right, not the obligation, to buy or sell an asset at a fixed price and time in the future. (a) Strike price- price at which the option is exercised. (b) Expiration date- the day the option expires. (c) Call Option- owner has a right to buy an asset. (d) Put Option- owner has a right to sell an asset. (8) Derivative Securities: Features embedded in them like callability, convertibility. Attractive to hedgers. Basic building block approaches of debt and equity.

The Lake Wobegone Effect

*We overestimate our own abilities! -Everyone cannot be above average -Causes people to overestimate their knowledge, underestimate risk, and exaggerate their ability to control events Ex: All women are strong, all men are good looking, and all children are above average

Managing Credit Risk

-A major part of the business of financial institutions is making loans, and the major risk with loans is that the borrow will not repay. -Credit Risk: The risk a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal. -The concepts of adverse selection and moral hazard will provide our framework to understand the principles financial managers must follow to minimize credit risk, yet make successful loans. -Adverse selection is a problem in the market for loans because those with the highest credit risk have the biggest incentives to borrow from others. -Moral hazard plays a role as well. Once a borrower has a loan, she has an incentive to engage in risky projects to produce the highest payoffs. Solving Asymmetric Information Problems: financial managers have a number of tools available to assist in reducing or eliminating the asymmetric information problem: 1. Screening: Collecting reliable information about prospective borrowers. This has also lead some institutions to specialize in regions or industries, gaining expertise in evaluating particular firms or individuals. 2. Monitoring: Requiring certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contact. 3. Long-term Customer Relationships: Past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness. 4. Loan Commitments: arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan. 5. Collateral: A pledge of property or other assets that must be surrendered if the terms of the loan are not met (the loans are called secured loans). 6. Compensating Balances: reserves that a borrower must maintain in an account that act as collateral should the borrower default. 7. Credit rationing: (1) lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or (2) lenders will only finance part of a project, requiring that the remaining part come from equity financing.

Taxable Bonds and the Taxable Bond Market

-Corporations issue bonds to finance their long-term capital project needs and to take advantage of tax deduction associated with the interest payments on debt -Bonds are issued in the primary market at a yield based on the spread to Treasuries that is required for an issue with the appropriate risk -Corporations also issue bonds known as convertible bonds that usually pays a fixed-rate of interest, and after a certain period of time, can be converted into a fixed number of shares of the issuing corporation (conversion features require lower yields and investor has a say in when to convert them) -Companies in capital intensive industries (utilities or manufacturing) issue more debt than industries that are subject to technological changes like Microsoft -Mortgage-backed bonds and the asset-backed bonds, secured by car loans, credit card receivables, and other structured bond issues are usually created by financial institutions that originate the loans that are then pooled and marketed to institutional investors (secured by assets) -These bonds are sold to investors in the primary market through an investment banking syndicate and are traded in the secondary over-the counter market

Efficient Capital Markets

-Efficient capital markets are very tough to beat -If a market is efficient, all investments are properly priced, and the value of the investment is equal to that price. Why should a market be efficient? -Asset prices react very quickly to the receipt of new information. -New information is random. Can be good or bad. -Quick reaction of many market participants to new information tends to drive prices to their "correct" level. What is an Efficient Market? ->A market where all investments are accurately priced. This means there are no good investments and there are no bad investments! -Each investment offers an expected return to match its level of risk (systematic risk measure by the asset's beta) Ex: At 11:00, IBM announces good news. In efficient markets, the adjustment is immediate. Otherwise, we would see a trend (gradual adjustment)

Stock Value Versus Stock Price

-Emotions can determine a stocks price in the short-run (not in the long-run) Ex: Entremed drug that "cures" cancer causing stock price to increase Does the stock market ever over react or under react to new information? -> Can occasionally overreact and underreact to new information (investors cannot handle volatility of crises causing them to stop investing at the worst times and they lose money) Why don't brokers recommend selling a stock? -> Would kill the investment banking relationship with the firm (encourage buying)

Managing Interest Rate Risk

-Financial institutions, banks in particular, specialize in earning a higher rate of return on their assets relative to the interest paid on their liabilities. -As interest rate volatility increased in the last 20 years, interest-rate risk exposure has become a concern for financial institutions. -To see how financial institutions can measure and manage interest-rate risk exposure, we will examine the balance sheet for First National Bank (next slide). -We will develop two tools, (1) Income Gap Analysis and (2) Duration Gap Analysis, to assist the financial manager in this effort. Problems with GAP Analysis -Assumes slope of yield curve unchanged and flat -Manager estimates % of fixed rate assets and liabilities that are rate sensitive

Derivative Securities

-Financial instruments -Value derives from or is based on: 1. The value of a simple security or 2. The level of an interest rate or 3. Interest rate index or 4. Stock market index -Delivery occurs sometimes many years into the future, and buyer or seller can offset transactions -Many securities have features embedded in them that make them derivative securities, such as callable bonds, and convertible bonds *Value Call Option = Value Callable Bond - Value Non-Callable Bond -Derivative securities often are more sensitive to price or yield changes, and sometimes are more leveraged (Attractive to hedgers; can backfire for speculators) Ex: Let's assume that the 30-year bond that is callable in 10 years @ 100% issued by ABC Company is trading at 100% and has an 8% coupon. Let's also assume that the yield for a non-callable 30-year bond of a company with default risk similar to ABC Company is 7%. What's the value of the call option? -> Step 1: Non-callable bond present value PV = $1124.72 (Using calculator N= 60 (30x2), PMT= 40 ($80 per year), I/Y= 3.5 (7%/2) FV= 1000) -> Step 2: The value of callable bond= $1000 (N=20, PMT=40, I/Y=4.0, FV=1000) -> Step 3: Value of the call option is 1000 - 1124.72 = -$124.72

WACC: Expected Return for a Stock

-Returns for an individual stock should depend on risk of the stock -With increasing risk, investors should demand higher expected returns How is risk measured? -> Beta! How is expected return measured? -> CAPM! Formula: Expected Return from a Stock= Risk Free Rate + Beta x (Equity Risk Premium) Ex Microsoft: 5% + 0.79 (4%) = 8.16%

Important Formulas

CAPM = E(Ri) = Rf + ßi x (Rm - Rf) Where: Market Risk Premium = (Rm - Rf) Beta = Risk = ßi Alpha = Observed Return of Asset (Expected Return of Asset). How the asset performed based on expectation. Reminder: -Unsystematic Risk or firm specific risk is the risk that can be diversified away. Risk that you are not paid to take! -Systematic Risk is market related risk as measured by Beta. Risk that can not be diversified away. Risk you are paid to take!

An investment's beta determines its risk premium (example)

Ex 1: T-Bill Rate: 4%, Expected return on Market: 8%, Market risk-premium= 4% (8 - 4 = 4%). AOL has a beta of 1.6 AOL's risk-premium = (1.6 x 4%) = 6.4% AOL's expected return = (4% + 6.4%) = 10.4% Ex 2: T-Bill Rate: 4%, Expected return on Market: 8%, Market risk-premium= 4% (8 - 4 = 4%). ATT has a beta of 0.6 ATT's risk-premium = (0.6 x 4%) = 2.4% ATT's expected return = (4% + 2.4%) = 6.4%

Utility Functions

Normal Utility Function: -Defined in Terms of Wealth and Concave Shape -Indicates Risk Aversion (Greater Wealth Increases Utility, but in Decreasing Amounts) -Graph increase and curves right Utility Function with Loss Aversion: -Utility Function is Defined in Terms of Changes from Current Wealth. -It is Convex to the Left of Origin, Giving Rise to Risk-Seeking Behavior in Terms of Losses

Anchor/Reference Point

Reference point is a point of comparison; a benchmark. Examples of reference points: -Purchase point (entry point) -Present price -Highest purchase price -Lowest price after entry point -Five points below previous day's closing -Highest price stock reached after entry *Stock price path over time may influence reference point

What do we mean by Risk?

Risk: Measured by the possible range of returns around an expected return (part of an assets price movement caused by an unexpected event) -Measured by a statistic called the standard deviation of returns -Risk has both negative and positive outcomes. Generates returns that are lower than expected or higher than expected. 2 Types: 1.) Firm-Specific Risk (Unsystematic risk): Can be diversified away and affects one company or industry like a management/accounting problem, patent expiration, SEC investigation. 2.) Systematic Risk (Market Risk): Cannot be diversified away like changes in interest rates/inflation, or war that affect all stocks and investments.

Microsoft DCF Valuation

Step 1: Forecast Microsoft's expected cash flow Step 2: Estimate Microsoft's discount rate Step 3: Calculate the Enterprise value of Microsoft Step 4: Calculate Microsoft's per share stock value

Investment Implications: Overconfidence, Optimism, and Bias in Hindsight

Studies Show that People Will Bet More on a Coin Toss if the Coin Has Yet to Be Tossed. Why? -> Illusion of Control (better thinks they have control over the outcome) Key Elements: Choice (Lottery Numbers) Outcome Sequence (Positive Outcomes, Greater Illusion of Control) Task Familiarity + More Information + Active Involvement + Which is more likely in six coin tosses? HHHTTT or HTHTTH? -> Both are equally likely! (Hot Hand Fallacy) -The Hot Hand Fallacy: a) Attribute Causal Significance to Chance Events b) Leads to Overreaction c) Perceive Trends Where None Exists and Then Take on Action on Erroneous Impressions

Summary of cards 101-108

Summary •Management of risk -Risk associated with the returns of financial assets -Diversification, hedging and insurance to reduce risk •Diversification -Reduce risk by investing in not highly correlated assets -Reduce unsystematic risk -Costless way to reduce risk •Hedging -Reduce risk by sacrificing upside gain -Future, forward and swap •Insurance -Reduce risk by paying a premium. Option is similar to insurance -The intrinsic value of an option is the difference between the exercise price and current price •Derivative securities -The value is based on underlying simple securities -The market is more efficient, liquid and used to hedge risk

Practice question (Alpha and mutual funds)

The XYZ fund had a positive alpha using gross returns over the past five years. What is its expected alpha using gross returns for the next five years? -> Answer: 0% Using net returns? -> Negative the amount of expenses

Free Cash Flow to the Firm Valuation Approach

The discounted free cash flow to the firm (profits) valuation approach is a four-step process to value the stock of a company: Step 1: Forecast the company's Expected Cash Flow Step 2: Estimate its Weighted Average Cost of Capital Step 3: Calculate the Enterprise Value of the Company (what company is worth overall) Step 4: Calculate Intrinsic Stock Value (value of a share of a stock)

Risk and Return and the Capital Asset Pricing Model

There is a direct tradeoff between the expected rate of return and risk. Tradeoff represented by the diagonal line in a graph with Return on the y-axis and Risk on the x-axis and the line is going up. *As the inherent risk increases in an investment so does the expected return* Historically, lower risk investments have lower returns and higher risk investments have higher returns! Ibbotson and Sinquefield study: Return SD Treasury Bills 3.8% 3.2% Govt. Bonds 5.3% 9.4% Corporate Bonds 5.8% 8.6% Large Company Stock 10.7% 20.2% Small Company Stock 12.5% 33.2% *High standard deviations have higher returns and more risk*

Behavioral vs Traditional Finance

Traditional: -Markets are efficient (according to Modern Portfolio Theory) -Stock prices quickly change due to new information -> Modern Portfolio Theory factors... a) Random Walk Hypothesis b) Market Efficiency (assumes investors are rational and calculated. Impossible to outperform the market using known information, must get lucky) c) Capital Asset Pricing Model -Investors choose stocks that maximize utility, are rational and make informed decisions, reflect risk and return and the CAPM, price always reflects value, arbitrageurs correct mispricing in the market -New information is quickly reflected in market Behavioral: -There are psychological variables that are used when investing in the stock market -Provides opportunities for investors to profit -Based on the premise that traditional finance ignores that humans make mistakes -Explains how markets can be inefficient! -Investors find flaws in utility functions, use their emotions and are irrational when making decisions (use bias), there is no price vs. value, limits to arbitrage

Intro to Stock Valuation

Valuation: The value (current dollars, PV, hard cash) of any financial instrument (stock, bond, mortgage) equals the present value of its expected cash flows (think "real profits"), discounted (think "reduced") for risk and timing. -Stock Valuation depends most on profits (cash flows), and inversely on interest rates and risk. *As profits go up, stock prices rise. As interest rates and risk premium increase, stock prices fall (depends on profits, interest rates, and risk)*

Confirmation Bias

Your mind acts as a yes-man for your beliefs. -People are mentally lazy. It's easier to focus our attention on data that supports our hypothesis, rather than to seek out evidence that might disprove it. -A recent analysis of psychological studies with nearly 8,000 participants concluded that people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs.

How to Value a Stock (Announcement Definitions)

(1) In the short-run, stock prices are determined by supply versus demand. The stock market looks toward the future and reflects what is expected to happen out 1 day to 1 year. (2) In the long-run, stock prices increase with a company's higher profits, lower interest rates and risk. They decrease with higher interest rates and greater risk. (3) The stock of Entremed jumped from $13/share at Friday's stock market close to $84/share at Monday's open due to a very positive article in the Sunday New York Times. Some Internet High-Tech initial public offerings increased five-fold on the day they were marketed during the Internet heydays. (4) Fear and greed control the stock markets. *Average stock price volatility is 45% per year!* (5) There is great volatility in stock prices which depend on random future events and states of the economy that are impossible to predict. (6) Dr. Woolridge and I have written a book on stock valuation: "Streetsmart Guide to Valuing a Stock" that has been translated into Mandarin. (7) Stocks represent an ownership interest in a company. (8) Shareholders have a "residual claim" after everyone else is paid off. Limited liability! Partnerships and sole proprietorship you have full liability. (9) Greater risk or higher interest rates, the lower the stock's price. (10) Value a Stock: Discount the expected future cash flows, discounted by a rate that takes into account the time value of money and risk. (11) Corporation: A legal entity that has an infinite life. No scheduled maturity! (12) Perpetuity: An asset that has a stream of even cash flows that goes on forever. The value of a perpetuity = annual cash flow/Discount Rate. (13) Return to Stockholders = %Return = (Dividends + Change in stock price)/Beginning stock price. (14) Dividend Irrelevance Policy: Dividends should not affect current stock price. (15) Stock Valuation Approaches: a) Technical Analysis=Stock prices are influenced by psychology and emotions of the crowd. TA uses charts and graphs and frequent trading. b) Fundamental Analysis=A company's stock has a true or intrinsic value that the stock will gravitate to. c) Modern Portfolio Theory=Stock market is efficient and price always reflects intrinsic value. (16) Modern Portfolio Theory: Efficient Capital Markets-stock prices always reflect intrinsic value and is already embedded in a stock's price. Pick a risk level and diversify your portfolio. (17) Valuation--check out Valuepro.net

Bond Valuation and Interest Rates (Announcement Definitions)

(1) Interest rates are the costs of borrowing Money. The higher the interest rate the greater the cost of financing a house or a car or your college tuition. (2) Today, due to very low inflation, interest rates are very low. (3) Managing the level of interest rates is how the US government, operating through the Federal Reserve, influences the level of interest rates. (4) Low interest rates increases growth and increases the value of stocks and bonds, but it also increases the probability of inflation. (5) High interest rates slows growth and fights inflation. (6) In the US, the Federal Reserve is the lender of last resort and the Federal Funds Rate strongly influences the economy and foreign exchange rates. (7) A Bond is a debt security with a financial contract (an Indenture) under which the issuer is obligated to make periodic interest payments and repay principal. (8) The legal agreement between the issuer of the bonds and the investors in the bond is called the Indenture. (9) The yield on the bond is the expected rate of return if the investor holds the bond to maturity. (10) Stocks pay dividends. Bonds pay interest. The Coupon Rate on the bonds is the interest rate paid on the bond. There are fixed and floating rate bonds. (11) Fixed rate bond structures: the coupon rate does not change. The issuer pays a fixed interest rate during the bonds life. Par Bond-The Bond has a coupon rate that is set at issuance at a price that results in an 100% value. A Discount Bond is issued at a rate that will generate a price below 100%. A Premium Bond is issued at a price above 100%.

Random Walk Hypothesis

-A Random Walk is a path a variable takes where the future direction of the path (up or down) can't be predicted solely on the basis of past movements. The past cannot predict the future! Ex: Stocks are impossible to predict by looking at price patterns and trading trends -If stock markets are efficient, share prices react immediately to news. There is no predictable trend implied by a gradual market reaction. In an efficient market, share price changes are random.

Calculating Bond Yield

-A bond is valued by discounting bond's cash flows at the yield level that is required by securities of comparable maturity, risk, liquidity and call features. Hence, the computation of a required yield level is a function of all of these factors -The yield on a risky security can be represented by the yield on a comparable maturity risk-free security, plus a measure of the spread to Treasuries for default risk, plus a bond specific spread Formula: Bond Yield = Rf (risk free rate) + Spread to Treas. + Bond Specific Spread (callability or convertibility)

Why is beta a measure of "Market Magnification"

-A stock with a beta of 2 will tend to double market movements (up or down) -A stock with a beta of 0.50 will tend to have movements (up or down) equal to ½ the market

Fundamental Analysis

-According to Fundamental Analysis approach, the company's current and future operating and financial performance determine the value of the company's stock -The assumption underlying this approach is that a company's stock has a true or intrinsic value to which its price is anchored. *When there is an price divergence, the price over time will gravitate to its intrinsic value* -To assess a company's prospects, fundamental analysts evaluate overall economic, industry and company data to estimate a stock's value -Incorporate accounting (balance sheets, income statements) and is more long-term! -Examples of fundamental analysis approach include DCF valuation, target stock price and relative valuation. Target Stock Price: -Target Stock Price technique forecasts earnings per share (EPS) of a firm and multiplies EPS by the projected P/E ratio to arrive at a target stock price. EX: Suppose the projected EPS of XYZ Inc. is $2.50 and the market P/E ratio is 10. The target stock price of XYZ Inc. is $25 (P/E x EPS, 10 x 2.5 = 25). If the current market price of the stock is $20, a financial analyst would recommend buying the stock. If it was $30, sell the stock Relative Valuation: -Relative value analysis employ measures of value such as P/E ratios, price/book values (P/BV), price/sales (P/S), or the price/earnings/growth (PEG) ratios for a company and compares them with those of similar stocks and industry peers EX: McDonalds current P/E of 15.8 is below the P/E's of other fast food restaurant chains. Given that the company's growth in earnings and sales is in line with industry peers, and its risk profile is below that of its competitors, we conclude that McDonalds is undervalued and you should buy the stock. DCF (Discounted Cash Flow) Valuation: -In the DCF approach a stock's value is the sum of the expected cash flows of the company, discounted at an appropriate interest rate (time and risk) -The most basic DCF approach is the dividend discount model (DDM), under which an analyst estimates future dividend growth and the required rate of return on the stock and discounts those expected dividends to arrive at a stock's value. -Other DCF approaches are the free cash flow to equity (FCFE) model and free cash flow to the firm (FCFF) model.

Default Risk and Bond Ratings

-All taxable fixed-rate debt that is issued or traded in the U.S. capital markets is priced at what is called a spread to Treasuries (amount higher than U.S. Treasury debt) which is the measure of default risk on an asset-backed transaction or a specific company's debt -The interest rate, or yield, of all debt is vitally dependent on the risk-free rate associated with the comparable maturity U.S. Treasury debt -This spread will change over time depending on economic conditions and the relative default risk associated with the specific debt security -The Treasury Yield Curve is used as the risk free basis where all other securities/bonds are traded off of the comparable maturity, U.S. Treasury *Yield on all debt in the United States is based on the risk free rate of comparable maturity, U.S. Treasury debt* *The greater the default risk, the greater the yield on the bond and bond prices go down!* Spread to Treasuries: -The difference between the yield on a non-callable U.S. Treasury bond and the yield on a non-callable corporate bond with an identical maturity is called the spread to Treasuries and is a measure of the default premium associated with the corporate bond -The spread to Treasuries is a function of the type of industry the issuer belongs, the credit rating of the corporate bond and a function of the time to maturity of the bond -Measure default risk associated with corporate bonds *Spreads increase with maturity. Longer the maturity, the higher the spread. Spreads increase greatly with low credit ratings (below BBB/Baa) -Three rating agencies: 1.) Moody's Investors Services, 2.) Standard & Poor's Corporation, and 3.) Fitch Ratings Ltd. specialize in rating the default risk and credit worthiness of a bond issue and of corporate, municipal, and even sovereign government issuers -The agencies then assign the issue with a bond rating that ranges from the equivalent of AAA, the highest grade with a very remote chance of default, down to CCC, the lowest grade and currently in default -The ratings have significant bearing on the required yield on a bond in the marketplace *The better the credit rating, the higher the security, the lower the interest rate* *The lower the credit rating associated with a deal, the greater the risk, the higher the yield, the higher the borrowing cost (want the highest rating possible)* -Beyond the corporate credit risk rating is the risk classification specific to a particular bond issue of the company -Senior debt is usually the most secure debt issued by a company. In the event of liquidation in bankruptcy, the most senior debt is paid first and whatever is leftover is distributed to the rest of the debt holders -Subordinated debt is debt that follows senior debt in line for claims on cash flows and assets upon liquidation (assets)

Modern Portfolio Theory (MPT)

-Based on 3 concepts: Efficient Market Hypothesis, Random Walk Hypothesis, and Capital Asset Pricing Model -Pick risk level you can live with and diversify it (do not do your own research) -Efficient capital markets is a cornerstone of MPT and is the belief that stock prices always reflect intrinsic value, and that any type of fundamental or technical analysis is already embedded in the stock price. -As such, MPT devotees tell investors not to bother to search for undervalued stocks but instead to pick a risk level that they can live with and diversify holdings among a portfolio of stocks. -However, empirical evidence shows that there is value to careful stock selection.

Yield Curve as a Predictor of Short-Term Rates

-Based on empirical evidence, the yield curve has been a particularly poor predictor of future short-term interest rates. -However the rates implied by the pure expectations model of the yield curve is important because trading activity can effectively lock in the forward and zero-coupon rates that are implied in the yield curve, the yield discount rates can be used to value cash flows associated with bonds and valuation of derivatives

Bond Valuation and Interest Rates

-Bonds are complex and their value depends greatly on changing interest rates Bonds in General: -A bond is a debt financial contract under which the issuer is obligated to make periodic interest payments and repay the principal at some pre-determined time *Indenture=The legal agreement between the issuer of the bonds and the investors* -The amount that is originally borrowed and the amount that is repaid when the bonds mature and the principal payment is due is known as principal value, or par amount or a maturity value -Bonds are a debt security where the issuer pays periodic interest payments and repays the principle of the bonds at the maturity date of the bonds. -Other names for bonds: Loans, promissory notes, debentures, commercial paper, asset backed bonds, mortgage bonds, and general debt *Yield on Bond/Interest rate=The annualized rate of return an investor expects to receive if they hold that bond to maturity. Refers to time value of money and discount rate*

Risk and Return and CAPM (Announcement Definitions)

-CAPM is a theory that helps us to predict the expected return on a risky asset -There is a trade off between risk and return -T-bills have a low expected rate of return and no risk and an expected return of 2-3% -Small cap stocks have high expected return (10%-15%) and a great amount of risk -If you want high returns, you need to take risks -The observed rate of return on an investment equals the cash payments you received during your holding period, dividends (stocks) or interest payments (bonds) -Observed rate of return = ($4 in dividends) + ($14 in capital gains) both divided by the purchase price of $90 = ($4 + $14)/$90 = 20% -RISK on an asset is measured by the variability of returns (standard deviation). Greater volatility, more risk, greater expected returns and our measure of volatility is standard deviation -Standard Deviation measures how tightly or how widely returns cluster around and average return. Stock returns are assumed to have a normal distribution (bell curve). The greater the standard deviation, the wider the distribution, the greater the risk (focuses on the finance principal relating to investment valuation: Value equals the sum of expected cash flows discounted for time and risk) -When we plot the risk/return line in a graph, we see that we have an almost linear relationship. -Risk is measured by price and return volatility. "Firm specific risk" such as accounting problems, an SEC investigation, management problems CAN be diversified away by invested in different assets. "Systematic risk" such as inflation, interest rate movements, war—CANNOT be diversified away. - E(Ri) = R(f) + Bi x (Rm-Rf) = CAPM Equation

Optional Redemption (Bonds and Interest Rates)

-Call Option: Issuer's option to redeem bonds prior to their stated maturity, at a pre-determined price above par value (for long-term bonds). Valuable to the bond issuer and has a cost with it that is paid by the bond issuer (higher rate of interest than if the bond were non-callable) *If interest rates drop, the issuer of the bond would prefer to call in higher interest rate bonds -Call Premium: The excess amount of the call price above the par value -An investor that owns a callable bond is subject to considerable uncertainty about cash flows on its callable bonds and hence will require a higher yield on callable bonds than on comparable non-callable bonds

Introduction to Stock Valuation

-Common stock represents a pro-rata ownership interest in a corporation (can vote on with the board if you own stock) -The value of a stock depends on the firm's future profits or cash flows and the rate of return or required yield that is expected from the investment (take into account time and risk) -Higher profits increase a stock's market value and lower profits decrease its value—a direct relationship! -Higher interest rates decrease market value and lower yields and interest rates increase value—an inverse relationship! -Shareholders have a residual claim and limited liability with ownership of the company (cannot be sued and can only lose the amount you put into the share unlike a sole proprietor) *Greater the risk (higher TVM), the lower the value of the future cash flows (higher discount rate)* -A stock is valued in the same manner as any other financial asset (discount its expected cash flows at a risk-adjusted discount rate) Challenges: 1. The range of future cash flows for a stock can be enormous. Cash flows can be higher or lower than expected. We make simplifying assumptions regarding the expected cash flows. 2. A corporation is a legal entity that has an infinite life and the valuation procedure must address the issue of valuing cash flows to infinity (stock has no fixed maturity and is discounted to infinity) -Perpetuity=An asset that has a stream of even cash flows that continue to infinity. -The value of a perpetuity is calculated by dividing the level annual cash flow associated with the perpetuity by the discounting rate: -> Formula: Value of a Perpetuity = Annual Cash Flow/Discounting Rate Ex: $100 million in cash flows, 10% in WACC (discount rate), so... $100 mil / 0.10 = $1 billion

Tests of Market Efficiency

-Goal of many of the studies is to find investment strategy that produces investment returns greater than a long-term buy-and-hold strategy for a diversified portfolio of stocks. -The majority of studies have shown that new information is quickly incorporated into stock prices. The excess returns arbitraged away and that stock market is relatively efficient, or at least semi-efficient (new info is processed so quickly, that it is useless to use old info for predictions) -Want to diversify portfolios, minimize transaction costs, and pick risk level/beta that you can live with Behavioral Finance: -Academicians who specialize in the field of behavioral finance, have challenged Modern Portfolio Theory's assumption that investors are rational and markets behave rationally. -Behavioral theorists have conducted studies that show that stock markets were not efficient and people and markets, at times, behave irrationally (investors hate losing, so they hold onto stocks longer than they should, can be overconfident/optimistic, and dramatic when investing in the market) The Fama and French Study: -Fama and French study compares the performance of the returns associated with portfolios of stocks that have certain similar characteristics -The study showed, among other things, portfolios of stock with a high book value/equity (BE) to market value/equity (ME) ratio consistently outperformed portfolios with low (BE/ME) ratios and called to question the validity of efficient capital markets -F&F Study shows interesting anomaly (different portfolios had different outcomes and ones like value stocks, low tech, and utility stocks outperformed) *Markets may not be all that efficient! Some techniques can outperform the market* -Finds that stocks with low p/e ratios outperform stocks with high p/e ratios -Stocks with small market caps outperform stocks with large market caps. -Other researchers find roughly the same results. Less Technical Evidence from the Real World: -Evidence indicates stock price changes are independent. -Evidence indicates stock prices react quickly to news and excess returns are arbitraged away. Evidence From Mutual Funds: -Studies of Mutual Funds using gross returns have shown that mutual funds do no better than to lie on the risk-return line (alpha of zero). -Net returns (gross returns less fees) give a negative alpha. -In an efficient market, funds with the lowest fees have the greatest alpha. *Buy funds with the lowest fee possible* Evidence on Individual Investors: -A study of 60,000 individual accounts at a discount brokerage firm showed that trading costs negatively and significantly affect the returns of market participants (active traders had the lowest annual net return) -Investors can improve returns by reducing transactions costs to the lowest level possible. *Reduce costs to the lowest levels possible!

Efficient Capital Markets and Random Walks (Announcement Definitions)

-If markets are "efficient" then all assets are properly priced -Stock prices react very quickly when the company announces new information. Info is random (good or bad). The quick reaction of many market players drive prices immediately to "correct levels." -An Efficient market it is where all assets are priced accurately; a) The Bad news is that there are no good investments; b) The Good news is that are no bad investments; c) Each investment offers expected return to match its systematic risk; d) If a market is efficient all investments lie on a risk/expected return line. -Efficient markets react to the receipt of new information instantaneously. Immediate adjustment. -Random Walk Hypothesis: Random Walk is a path that a variable takes when the future direction of the path can't be predicted solely on the basis of past price movements. -3 Forms of Market Efficiency: 1) Weak Form: Stock prices already reflect info contained in the history of past prices and volume; 2) Semi-Strong Form: Stock prices all info including info not available to the investment community; 3) Strong Form: Stock prices reflect all info, including info not available to the investment community. -Goal of the studies is to find a strategy to produce returns higher than long-term buy and hold strategy for a diversified portfolio of stocks. -Behavioral Finance=Investors may not be rational and markets may behave irrationally. -Fama and French Study=High book value to market value stocks outperform portfolios with low (Book Equity/Market Equity) stocks. Markets may not be all that efficient!!

Liquidity Preference Hypothesis

-Liquidity Preference Theory=Most investors prefer to hold short-term maturity securities and hence in order to induce investors to hold bonds with longer maturities, the issuer must pay a higher interest rate as a liquidity premium -Thus under this theory, long-term rates are composed of expected short-term rates plus a liquidity premium which increases with time to maturity -This theory implies an upward-sloping yield curve even when investors expect that short-term rates will remain constant -Has elements of pure expectations and inserts risk aversion Graph: -Liquidity Premium Theory Yield Curve increases slightly over time with an arched curve. The Pure Expectations Theory Curve is constant and the space below the Liquidity curve and above the Pure Expectations curve is the Liquidity Premium amount *Most financial people use this curve!

Stock Market

-Looks toward the future (reflects what is expected to happen in a few months or years) -In the short-run, stock price is a function of supply vs. demand -Stock price can be extremely volatile (risky) -It is hard to know when a good time to buy a stock is due to public information making it more popular at any given time (or it can go down/crash) -In 2008 crisis, market went down 50%, but hit new highs since then -With the short-run, there is fear of downsides and greed on upsides (people buy more when they see stocks going up and sell when market is bad) -Stock returns depend on random future events and states of the economy that are impossible to predict *In the long-run, stock prices/value vary directly with the profits of the company and vary inversely with changes in interest rates or risk (higher profits expect higher stock prices, higher risk/interest rates expect lower stock prices)*

Municipal Bonds and the Municipal Market

-Municipal bonds are debt instruments issued by states, cities, municipal authorities and other entities -*Municipal bond interest income is exempt from federal and certain state and local income taxation* -Investor can compare Municipal Bonds interest income with after-tax income of other fixed-income securities, taking into account the investor's marginal tax bracket -The municipal bond market is a huge, diverse, and extremely complicated marketplace -Are complicated markets -Interest rates are often lower than comparable maturity Treasury rates (tax exemption is desirable) -For Treasury bonds, the income interest is exempt from state taxation (Doctrine of Reciprocal Immunity) Formula: Post-tax income = Pre-tax income - Exemption from taxation Municipal Bonds Example: -> An investor in the 30% tax bracket purchases a municipal bond that pays a tax-exempt interest rate of 6%. Calculate the taxable equivalent municipal bond yield... Taxable Equivalent Bond Yield (r) = Coupon rate / (1-t) r = 6 / (1 - 0.3) = 8.6% Taxable Equivalent Bond

Stock Valuation Approaches

-Professional stock market participants practice a number of investment approaches and techniques which are classified as fitting into one of three camps: 1.) Fundamental Analysis, 2.) Technical Analysis, and 3.) Modern Portfolio Theory (MPT) -The three philosophies have different beliefs about the relationship between the stock prices that we observe in the markets and underlying intrinsic stock values. How to Value a Share (Grid): -In Technical Analysis, Psychology Technical Cosmic drives stock prices. Trends, waves, and factors are used to value a share, and price does not equal value. -In Fundamental Analysis, earnings and dividends drive stock prices. Forecast and dividends/earnings value a share. Price will eventually equal value. -In Portfolio Theory, risk and return drive stock prices and value and share. Price equals value.

Reinvestment Risk

-Reinvestment risk is the risk that arises from reinvesting the periodic interest payments on fixed-rate bonds (the uncertain interest rate the bond holder faces when they receive a coupon payment from the bond and wants to reinvest that payment into the marketplace) -An investor receiving payments over the life of a coupon-bearing bond faces the risk of reinvesting coupon payments at uncertain future interest rates than may be lower than the yield on the bond -The yield to maturity on coupon bonds depends significantly on the reinvestment rates (coupons are rolled over at the yield on the security) -Buy zero coupon bonds to only pay a one time interest payment and have no reinvestment risk *If you have higher rates, your reinvestment risk would exceed your initial yield to maturity*

Standard Deviation of Return (s or sigma)

-Risk on an asset is measured by the variability of returns -Standard deviation is the statistic that is that measures how wildly or tightly observed stock returns cluster around the average stock return -Shows a bell curve *Greater standard deviation means more fluctuations and greater risk* Calculation of Standard Deviation of Return: Ex: The annual returns of stock of XYZ Inc. for the last three years was: Year 1 - 8% Year 2 - (1%) Year 3 - 2% *Step 1 : Take the simple average/mean return of the distribution -> 8 - 1 + 2 = 9% / 3 observations = 3% per year (average rate of return) *Step 2: Take each individual observed return and subtract the average of the returns -> Year 1: 8 - 3 = 5% Year 2: -1 - 3 = (4%) Year 3: 2 - 3 = (1%) *Step 3: Square the resulting difference and add the squares to get the sum of the squares -> Year 1 = 5% (.05), so take 0.05^2 = 0.0025 Year 2 = 4% (.04), so 0.04^2 = 0.0016 Year 3 = 1% (.01), so 0.01^2 = 0.0001 Then, sum all of the squares (0.0025 + 0.0016 +0.0001 = 0.0042) -Your Squared Deviation Total is 0.0042 *Step 4: Divide the sum of the squares by (the total number of observations minus 1) the result is the variance of the distribution -> Variance = 0.0042/(3-1) = 0.0021 *Step 5: The square root of the variance is the standard deviation of the returns -> Standard Deviation = 0.0021^1/2 = 4.58%

Step 4: Calculate Microsoft's Per Share Intrinsic Value ($51.32)

-Start with total corporate value: $478.044 Billion -Subtract value of debt ($12.601 Bil.) + preferred stock (0) + short-term liabilities ($37.417 Bil.) -Divide the difference of $428.028 Billion (Total Value to Common Equity) by shares outstanding: 8.35 Billion -Result = $51.32 Intrinsic Stock Value

Excess Return Period and Competitive Advantage

-The Excess Return Period is the period during which a company is able to earn returns on new investments that are greater than its cost of capital because of a competitive advantage enjoyed by the firm (patents, brand name) that lets them get extra rate of return -Success attracts competitors and over time a company loses its competitive advantage and the return from its new investments just equals its WACC (i.e. investors are just compensated for the risk that they are taking in owning the company's stock and no additional value is created from new business investments). Depending upon the excess return period companies can be grouped into 4 categories: 1.) Boring Companies: Operate in a highly competitive, low-margin industry (1 year excess return period). Need to seriously compete and cut prices. 2.) Decent Companies: Decent reputation, don't control pricing or growth in their industry (5 year excess return period). 3.) Good Companies: Good brand names, large economies of scale (7 year excess return period) 4.) Great Companies: Great growth potential, tremendous marketing power, brand names (10 year excess return period)

Buy/Sell Decisions should be based solely on Price Versus Value!!! (When to buy or sell a stock)

-The best company is a poor investment if you pay too much! (company values can change over time and get better or worse) Buy Decision: *If the stock's value is greater than a stock's price by (X)%, buy it* Sell Decision: *If the stock's value is less than a stock's price by (Y)%, sell it*

Structure of Interest Payments on Bonds

-The coupon rate or interest rate on a bond is the rate, expressed on a percentage basis, at which interest accrues or is paid by the issuer to the owner of the bond *Coupon Rate=Annual interest amount (cash flow) calculated on a percentage basis that is paid on a bond. Determines the bonds annual cash flows! Refers to cash flows* -Interest rate setting structures vary and can be broadly classified into two categories a) Fixed Rate Structures (rates stay the same) b) Floating Rate Structures (coupon rate fluctuates) -Interest rate setting structures affect the value of a bond Fixed Rate Structures: -The coupon rate and payments are fixed over the life of the bond, and the investors and the issuer are certain of the payments -In a Fixed Rate Par Bond, the issuer issues the bond at par value and pays fixed interest semi annually on predetermined dates and repays the full par value of the bond on maturity -Par bonds has a coupon rate set at a level where the bond trades at 100% in the marketplace (market value is 100%). The coupon rate is its yield for par bonds *Coupon rates are set and do not change* -In a Fixed Rate Discount Bond, the bond is issued at a coupon rate that creates a market value of less than par at the time of pricing, and offering an yield that is higher than the coupon rate (coupon rate lower than its yield and market price lower than 100%) -In a Fixed Rate Premium Bond, the issuer will market a bond with a coupon and interest rate that creates a market value of more than par at the time of pricing, and an offering yield that is lower than the coupon rate (coupon rate higher than yield and market price greater than 100%) Ex: Treasury issues 3% coupon bond and the yield is 4% in the marketplace, the bond will sell at a price lower than 100% (discount bond) *Investors retain the interest rate risk associated with bonds (if interest rates go up, the market value of the bond goes down)* *The INVESTOR takes on the interest rate risk! Floating Rate Structures: -In floating interest rate instruments, initially interest rate setting mechanisms were based upon some interest rate index or level of a risk free security -Over the years, rate setting mechanisms have been developed that are designed to create a bond that always trades at or near par value -Historically, the floating interest rates have been significantly lower than the rates on fixed-coupon bonds. However, the issuer retains the interest rate risk inherent in a bond issue *Keep bond prices at par (100%). If market interest rates go up, the bond interest rates go up and vice versa* *In floating rate structures, the ISSUER retains the interest rate risk! Also have lower yields.

Stock Value and Dividend Policy

-The dividend policy of the firm should NOT affect the current value of a stock! -However, the expected future value of a stock IS greatly affected by dividend policy. -Called Dividend Irrelevance Policy (current price of a stock does not depend on dividends, but future price does) -When a company does not pay dividends and reinvests its earnings in projects, the investors receive no current dividend but instead receive an increase in stock price.

Duration (Bond and Interest Rates)

-The price volatility of a debt issue is measured using duration -The duration of a bond is measured in units of time (for example, 7.3 years). -In the simplest case, the duration of a zero coupon (no interim payments) bond is equal to its current time to maturity *The higher the current coupon payments, the lower the price volatility and the shorter the duration* -Takes into account the term of the bond (how long it is), the coupon associated with it, and it creates an average life in years -Duration is also defined as a percentage change in the price of an asset, divided by a change in interest rates. *There is an inverse relationship between interest rate movements and bond prices* Formula (get an approximation): D = (-∆ P/ P) / ∆ y Where... D = Duration, P = dollar price of a bond, ∆P = change in dollar price of a bond, y = market yield, and ∆y = change in market yield

Security (Bonds and Interest Rates)

-The sources of security on a bond issue can vary a great deal, and will affect the credit rating and creditworthiness of the issue -Securities that are issued by the U.S. Government are usually assumed to be risk-free -Municipal bonds may be secured in a variety of ways such as by the issuer's taxing power, revenues and credit enhancement devices (can be complex bonds). Interest payments are free from U.S. income taxation -Bond holders are conservative investors (risk averse) -Bonds can also be revenue bonds (PA Turnpike) -Bonds can be risky, but some are tax free -Corporate debt is most often an unsecured promise by the corporate to pay its debts. Sometimes the bonds will be secured by collateral or a mortgage on a particular property or piece of equipment (very risky and secured by corporate revenues like PP&E) -Asset-backed securities are secured by the sponsor who structures the financing and usually purchases credit enhancement (funded by mortgages and car/student loans)

Yield Curve

-The yield curve is the relationship between the yields and the maturities on Treasury securities. -The yield curve usually is positively sloped which means that short-term interest rates are lower than long-term rates and investors require higher returns for longer maturity Treasury securities. This is because the prices of longer maturity bonds are more volatile and therefore are viewed as being riskier than shorter maturity securities. *Long-term bonds have higher yield which have higher risk and a higher expected return* -Rates are very low today due to coronavirus and bad economy, but the Fed is trying to resolve it

The Term Structure of Interest Rates

-The yield curve, also known as the term structure of interest rates, describes the relationship between the yield on a security and its maturity (TVM or term structure of interest rates) -The shape of the yield curve, depending on the rate of inflation or deflation, the economy and monetary policies, can be upward sloping (which is the most common 90% of the time), downward sloping - when a significant slowdown in inflation is anticipated, flat, or humped -Several hypotheses attempt to explain the term structure of interest rates and the information that it conveys to the market -The three most common explanations are: 1. Pure expectations hypothesis (yield curve as a function of expected future short-term interest rates and assumes investors are risk neutral and want to maximize their returns) 2. The liquidity preference hypothesis (long-term rates are composed of expected short-term rates plus a liquidity premium and assumes investors are risk averse who prefer to hold short-term maturities with lower interest rate risk rather than long-term ones) 3. The market segmentation hypothesis/preferred habitat theory (the market is composed of diverse investors with different needs in supply and demand curves. Investors want life of assets to match the life of their liabilities)

Call Features and Other Factors

-The yield level on a bond is influenced by its liquidity, call features and other factors *With greater liquidity the bonds are more marketable and there is less of a liquidity yield premium associated with the bond -Investors analyzing a corporate, municipal, or asset-backed bond assign a premium in the way of a higher interest rate to reflect any optional and extraordinary call provisions in the issue *Non-callable bonds have lower yields than callable bonds* -Convertible bonds have greater value than non-convertible bonds

Professor's Valuation Philosophy

-There is value to careful stock selection (FA). -Timing of purchase and sale of stock is important (TA). -Diversification is good (MPT). -Value each stock holding individually and buy shares that are undervalued by (15)% and sell shares that are overvalued by (15)% *Buy undervalued stocks and sell overvalued stocks*

CAPM: The Trade Off Between Return and Risk

-Trade-off is between the expected return on an investment and its risk. -Low risk Treasury Bills have lower expected returns (2-4%). Stocks (large price volatility) have higher expected returns (e.g. 6-10%). -Risk measured by price or return volatility. More price/return movement—greater risk. -A rational investor requires a higher expected return to accept additional risk. -Model that describes this trade-off is the CAPM *Higher returns require higher risk and rational investors are risk averse*

Valuing a Bond

-Two important facts associated with valuation and bond prices in the marketplace are: 1. Bond prices and changes in interest rates move in opposite directions! (if interest rate goes up, bond value goes down) 2. Investors and traders value and bonds based on a price to worst call feature scenario (ex: Issuer of the bond will act in its own best interest in calling or managing the bond's call features and will exercise the call at the first available opportunity that is economically advantageous to the issuer) Ex: A callable bond must be valued based on whether or not it is called. If it is called, the bond will trade at the lower of the two call prices (assuming it is rational for the issuer to take it)

Pure Expectations Hypothesis

-Under Pure Expectations Hypothesis the yield curve can be analyzed as a series of expected future short-term interest rates that will adjust in a way such that investors will receive equivalent holding period returns -Thus the expected average annual return on a long-term bond is the compound average of the expected short-term interest rates *Thus an upward-sloping yield curve means that investors expect higher future short-term interest rates and a downward-sloping yield curve implies expectations of lower future short-term rates* Ex: A 1 year bond has a rate of 4% and a 2 year bond has a rate of 5%, so both bonds should yield the same rate of return over the 2 year period (implied forward rates like in hedging)

Mutual Fund Performance

-Using gross returns, the average fund has an alpha of 0% -What is the average alpha using net returns? -> 1.2% -Is good performance in the past (using gross returns) an indicator of good future performance? -> NO!! 89% of funds failed to match the S&P500 over the past 5 years *Index Funds are hard to beat *Buy funds that have very low expenses to avoid losing profits!

Valuing a Bond Example Problem

-Value the bond of XYZ Inc. which has a face value of $1000, maturity of 10 years and pays interest semi-annually at a coupon rate of 8% -Calculate the cash flows from the bond... 6 months = $40, 1 year =$40, 1.5 years = $40, 2 years = $40, End of 10 years = $40 + $1000 -Since it is semi-annual, you get $80 per year (8% of $1,000 per year = $80 per year), but $40 for every 6 months (coupon payment)

Step 1: Forecast Expected Cash Flow (DCF Valuation for Microsoft)

-We use the DCF free cash flow to firm to value Microsoft's stock -Free cash flows are cash amounts that are available to be paid to stockholders and can be reinvested by the company *Activities that produce net cash inflows to firm have positive effect on stock value* *Activities that produce net cash outflows from firm have negative effect on value*

What Do We Mean by Returns? Simple versus Compound Averages of Returns

-When Analyzing Returns, Simple Averages are Never Simple -Many investment managers and advisors use simple averages to portray their historic performance -However, simple averages are a misleading way to assess investment returns (compound or geometric averages are far more representative of actual investment performance) *Geometric average is calculated as below: (Value at the end of the period/Value at beginning of period)^1/T T = the number of years in the compounding period

Stock Valuation and Microsoft (Announcement Definitions)

1) Today we examine stock valuation #2, Is Microsoft Worth $311.8 Billion? 2) This study was done in year 2,000, 21 years ago. Today, MSFT is worth much more than 311.8 Billion. 3) We will answer: (a) How a stock market comes up with a stock's price? (b) Why stock prices react so violently to small negative earning surprises? (c) How do interest rates affect a stock's price? (d) How does the Internet affect stock prices? (e) When should I sell a stock? 4) Our goal is to use the Discounted Cash Flow to find the intrinsic value--what it's worth, of a firm. 5) Valuing a stock: (a) Value- Like other financial assets it equals the present value of the expected cash flows discounted for risk and timing. (b) Stock values depend mostly on profits, interest rates and risk. 6) The best company is a poor investment if you pay too much for it. 7) Discounted Cash Flow (DCF) assumes that a companies stock price will move towards its intrinsic value. (a) used for long-term buy/sell decisions. (b) Investment Decision Rule: If Price<Value, Buy, if Price>Value, sell. 8) Where to get info for stock valuation: the company's financial statements and announcements and many Internet sites. 9) Value Microsoft typing MSFT into the Valurpro.net web site. Just type: Valuepro.net

Bond Valuation and Interest Rates continued (Announcement Definitions)

1) a) Yield: Expected rate of return for a bond; (b) Coupon Rate: Interest cash flows associated with the bond; (c) Interest Rate: The discounting rate associated with the cash flows (TVM); (d) Fixed Rate Bond: Bond owner takes on the interest rate risk; Par Bond Rate: Market value equals 100%; Discount Bond: Yield is higher than Coupon Rate and Bond price is less than 100%; Premium Bond: Yield is lower than Coupon Rate and the price is greater than 100%. 2) Interest Rate Risk: a) Maturity: Longer the maturity the greater the price volatility, the greater the risk. b) Coupon: The lower the coupon on the bond, the greater the risk. c) Duration: Measured in units of time. Zero coupon bonds have a duration equal to the current time to maturity. There is an inverse relationship between interest rate movements and bond prices. 3) Yield Curve: The relationship between yields and maturities on Treasury securities. Usually it is positively-sloped (higher expected returns for longer bonds) 4) Municipal Bonds: Issued by states, cities, municipal authorities. Interest on muni bonds is exempt from federal taxes and certain state and local income taxes. *Taxable Equivalent Bond Yield = interest rate/(1-tax rate). 5) Corporate Bonds: Issued by corporations to finance long-term capital needs. 6) Convertible Bonds: Bonds issued by corporations that can be converted into shares of stock. 7) Mortgage and Asset backed bonds: Bonds are backed by tangible assets or collateral. 8) Yield on a bond is dependent on time value of money, default risk, and other bond specific risks. 9) Term Structure of Interest Rates: a) Pure Expectations: Yield curve is analyzed as a series of expected future short-term rates and the long-term rate is the compound average of expected short- term interest rates. b) Liquidity Preference: People prefer short-term bonds to long-term bonds and must be compensated to take on higher risk maturities. c) Market Segmentation: Different preferred habitats and investors must be paid a premium to push the yield curve shape. 10) Real Rate of Interest: Difference between the nominal rate minus the rate of inflation. 11) Bond Yield = Risk Free Rate + Spread to Treasury + Bond Specific Spread EX: Value two 10-year 5% bonds in a 4% market for the Premium Bond and a 6% market for the Discount Bond. a) Premium Bond -> N=20, I/Y=4/2=2.0%, PMT=$50/2=$25, FV=$1,000, solve for PV=$1,081.75. b) Discount Bond -> N=20, I/Y=6/2=3.0%, PMT=$50/2=$25, FV=$1,000, solve for PV=$925.61. 13) Callable Bond: Value a bond to both its call date and to its maturity and the market price is the lower of the two prices.

Types of Market Efficiency

1.) Weak Form Efficiency: Stock prices reflect the information contained in the history of past stock prices and trading volume -Implies daily stock price changes are independent -Useless to try to detect and exploit trends in stock prices, but technical analysts on Wall Street make bets based on trends and market efficiency 2.) Semi-Strong Form Efficiency: Stock prices reflect all publicly available information (cannot research past info to find an investment that would outperform the market) -Implies stock prices react quickly to new info and prevents investors from earning abnormal returns 3.) Strong-Form Efficiency: Stock prices reflect all information, including information not available to the investment community (examine returns from corporate managers relating to their trades in their own companies shares to test market efficiency)

Using Financial Calculator to Value a Bond

A 10 year bond pays interest semi annually at 10% and interest rates for a 10-year bond of similar risk is 9%, calculate the value of the bond. -We input values in the financial calculator: N = 20 (since payments are received semi annually) PMT = $50 (10% coupon rate on $1,000 bond or $100 per year, so make $50 payment every 6 months) I/Y = 4.5% (semi-annual interest rate- 9/2 = 4.5) FV = $1000 Then solve for PV which is equal to $1065.04

Capital Asset Pricing Model (CAPM)

A theory that helps us predict the expected return on a risky asset given its level of systematic risk. *Systematic risk is measured using beta and used in this case -From the Risk-Return Line, we can estimate the expected return on a stock, E(Ri) -Expected return on stock (i), E(Ri) equals the Risk-Free Rate (Rf) + the stock's Beta (ß) times the Market Risk Premium—the return on the market (Rm) minus (Rf) Formula: E(Ri) = Rf + ß x (Rm - Rf) E(Ri) = Expected Return Rf = Risk free rate ß = Beta Rm = Return on the market

Valuing a Callable Premium Bond to Call Date

Assume that the 10 year, 10% bond is callable after 5 years at 101% of par value and the discount rate in today's market is 9%. -Since the bond is callable by the issuer we price it on the Price to Worst Scenario, which assumes the issuer will call the bond when it makes economic sense (need two different prices based on held to maturity and if it is called) -If the issuer calls the bond after 5 years at 101% of par value, the value of the bond is: N = 10 (5 x 2 = 10, semi-annual) PMT = $50 (10% x $1,000 = $100 per year, $50 every 6 months) I/Y = 4.5% (9/2 = 4.5%) FV = 1010 (can be called at 101%, so 1,000 x 101% = 1010) Find PV which = $1046.00 (price to call) -The value of a callable bond is the lower of the price to call, $1046 or the price to maturity N = 20 PMT = $50 I/Y = 4.5% FV = $1,000 Solve for PV which =$1065.06 (price to maturity) *Pick the price to call because it is cheaper ($1046)

DCF (Discounted Cash Flow) is a Type of Fundamental Analysis

Assumption: A company's stock price will move towards its intrinsic value. -Many market players use FA as basis for long-term buy/sell decisions. -Investment Decision Rule: If Price < Value, buy; If Price > Value, sell.

What is Beta?

Beta is how stock price moves relative to the market. -To find beta number, use ratio of Movement Return price/Market price -If percentage price movement of a particular stock is higher than the market, it will have a beta greater than 1. -If percentage price movement is less than the market in general, it will have a beta less than 1 -If the percentage price movement is the same as the general market, it will have a beta of 1 Ex: The Market Portfolio is 10% and IBM has a stock return of 8%. Since the return is less than the market, the beta will be > 1, giving IBM a beta of 0.8 (8/10=0.8)

Components of Rate of Return

Cash Payments-Dividends and Interest taxed as ordinary income (i.e. up to 35%): -Dividends: Quarterly payments made on some stocks (ownership) -Interest: Semi-annual payments made on bonds (debt) Change in Price-Capital Gain or Capital Loss: -Realized: You sell your asset and incur gain or loss (If realized, the gains or losses are taxed) -Unrealized: You continue to own your asset -Long-term gains and losses are taxed at a lower rate (e.g. 20%) -Short-term gains and losses taxed at a higher rate (e.g. 35%)

Free Cash Flow to the Firm (FCFF)

FCFF = Revenues - Operating expenses - Net investment (fixed and working capital) - Taxes -To calculate FCFF, we need six important cash flow measures The Cash Flow Variables (Microsoft-Baseline Valuation): -Revenue Growth Rate: Analyst 5-year exp. profit growth rate is 7.2% -NOPM (Net Operating Profit Margin): 2011-13 avg.= 28.3% -Tax Rate: 2011-13 avg.= 20% -Investment: 2011-13 avg.= 4.5% -Depreciation: 2011-13 avg.= 4% Incremental Working Capital avg.= 4% Where... 1. Revenue Growth Rate = Annual expected growth in revenues 2. NOPM = Operating Income / Revenue 3. Tax Rate = Taxes / Pre-tax income 4. Incremental Working Capital = Change in Working Capital / Revenue 5. Fixed Capital Investment = (New investment - Depreciation) / Revenue

Bonds and Risk

Four types of risk involved while investing in fixed-rate or fixed-coupon debt obligations are... 1.) Default Risk: The risk that the bond will not pay interest or principal when due 2.) Reinvestment Risk: The unknown rate at which cash inflows may be reinvested (as received by the bond holder) 3.) Prepayment Risk: When an issuer calls a bond prior to its maturity 4.) Interest Rate Risk: The risk that a change in market interest rates will affect the value of the bond

Long-Term Return and Risk of U.S. Securities

From 1926-1999: The Capital Asset Pricing Model line was linear by showing which investments had the highest amount of risk. Ex: On the bottom left side (lowest risk/return) was Treasury Bills, then L-T Govt. Bonds, L-T Corporate Bonds, Common Stock, then Small Company Common stock was at the top right (highest return/risk)

Ranking Risks and Returns

From low to high: 1.) Treasury Bills have no risk and the return in certain (low volatility) 2.) Government Bonds 3.) Corporate Bonds 4.) Low-risk Stocks (utilities like Microsoft) 5.) Market Portfolio (includes all stocks) 6.) High-risk Stock (high returns, very volatile) *High risks give high returns*

Is a Stock Fairly Valued?

How are market expectations factored into a stock's price? -> Are usually embedded in stock prices! What happens when performance equals expectations? -> Markets do not react (If expected Microsoft growth is 10% and they announce it is 10%, the market stays constant. What happens when performance exceeds expectations? -> The stock price will be propelled upward (Google announcing their growth tripled causes their stock price to go up) What happens when performance is less than expectations? -> The stock price will go down *When you do NOT meet expectations, your stock price will fall*

Beta and Risk and Returns and How to Measure Beta

How do we measure risk of an asset? -> Beta What's the relation between beta and return? -> It is very positive (greater betas give higher returns) How do you measure Beta? -> Look at 60-120 monthly returns for a particular stock, plot the returns against monthly returns on the markets (like S&P) and the slope is beta. Ex: Scatter plot with Company return on vertical axis and market return on horizontal and the slope line is beta.

Valuing a Bond - Discount Bond Example

If the interest rates for an 8% coupon, 10-year bond of comparable risk were at 10%, we discount the $40 PMT at 10% (5% semi-annual), so... N = 20 (10 x 2 = 20 since it is semi-annual) I/Y = 5% (10 / 2 = 5) PMT = 40 ($80 per year, $40 every 6 months) FV = 1000 (maturity at 10 years) Solve for PV which = $875.38 *The market price of this bond is below or at a discount to its face value and is known as a discount bond *A discount bond has a coupon that is lower than its yield

Interest Rates

Interest rates are the cost for renting money. -High interest rates are more costly to buy things like cars or houses -Credit card rates are 15% -Savings accounts are < 1% *Pay off credit balances on time every month! -Lower interest rates encourage growth and increased economic activity, but can cause inflation -High interest rates slows economic activity, but fights inflation -The FED targets short-term interest rates (FED Funds Rate) which influence international interest rates and foreign exchange rates -The current FED Funds Rate is very low (0-0.25%) -They use Quantitative Easing with long-term governments and mortgage related bonds

Stock Valuation Questions

Is Microsoft really worth $311.8 Billion? -> Maybe/yes (if valued correctly) How does the stock market come up with a stock's price? -> Aggregate cash flows, take the present value, subtract liabilities, add assets, and divide by shares outstanding Why do stock prices react so violently to small earnings surprises? -> Companies hate to disappoint the marketplace and strive to meet expectations to avoid a drop in stock price due to underperformance How do interest rate changes affect a stock's value? -> Through the discounting process (when interest rates go up, value of stock goes down) When should I sell a stock? -> When its value falls below a certain price

Step 2: Microsoft Cost of Capital Inputs

Market Stock Price= $37.35 Beta estimate (MSN)= 0.79 Risk-Free 10-year rate= 5.0% Market Equity Risk Premium= 4% Shares Outstanding= 8.35 Billion Bonds Outstanding = 12.601 Billion Spread to Treasuries (AAA)=1.5% Total Current Assets= $101.466 Billion Total Current Liabilities= $37.417 Billion *Put these numbers into a stock valuation program (Valuepro.net) and you get the intrinsic value of the company

Let's Draw Today's Risk-Return Line

Put half your money in T-Bills and half in the S&P500. Your portfolio has a beta of 0.50 and has an expected return of 9% -By splitting your money between T-Bills and the market portfolio, you can obtain any point on the risk-return line/slope -By putting all your money in the S&P 500 and borrowing still more and putting that money in the S&P 500 ("leveraging" or buying stocks on margin), you can obtain any point on the risk-return line (risk taking investors like hedge funds). If incorrect, can incur extreme losses -Any point on the risk-return line can be obtained with the S&P 500 and T-Bills *To measure observed performance, use alpha (a). To measure risk, use beta* -A positive alpha is good, a negative alpha is not so good *(Positive=Observed return is greater than the expected return and is above the risk line. Investors outperform the market. Negative=Investment performs below the risk return line and investors underperform the market)* -Remember, the Risk-Return line is also called the zero-talent line so performance below the line is poor Ex Problem: T-Bills averaged 4% over last few years, S&P 500 averaged 14%. The XYZ Fund had an average return of 16% and a beta of 1.4. Find XYZ's alpha. -> Market risk premium is 14 - 4 =10% and risk free rate is 4% The CAPM risk-return line for a beta of 1.4 is: 4% + [1.4 x 10%] = 18% (expected return) XYZ's alpha is: 16% - 18% = -2% (avg. return - expected return) *XYZ underperformed since actual return is 16% and expected was 18% Ex Problem: T-Bills averaged 4% over last few years, S&P500 averaged 14%. The Nittany Lion Fund had an average return of 16% and a beta of 0.80. Find Nittany Lion's alpha. -> Market risk premium = 10% (14-4), Risk free rate = 4%, beta = 0.8 CAPM => 4% + (.08 x 10%) = 12% (expected return) Alpha: (Avg. return - expected) 16% - 12% = 4% *They outperformed the market (16% is greater than 12% and alpha is positive)

Growth vs. Value, Large Cap vs. Small, Tech vs. non-Tech?

Should the classification of a stock affect it's value? -> NO! -The only thing that matters is price related to value!! -Classification does affect cash flow measures (higher growth rates, larger NOPM's, higher required investment); and a company's discount rate (higher for the riskier cash flows) -Use Fundamental Analysis to accurately look at stocks (price will eventually equal value)

The Risk-Return Line

Shows the tradeoff between expected return and risk as measured by beta. Look at 2 points: 1.) Risk associated with an investment has beta of 0 2.) Risk of investment has a beta of 1 T-Bill Rate is 5%. Market Risk Premium has averaged 8%. Expected Return on the Market (i.e. S&P500) is 8% + 5% = 13% *Beta of 0 is at 5% and beta of 1 is at 13% (riskier)

Discounted Cash Flow: A Four Step Approach to Valuation

Step 1: Forecast Expected Cash Flows (think "real profits") Step 2: Estimate the Discount Rate (think "interest rates") taking into account time and risk. Step 3: Calculate the Enterprise Value of the Corporation (full value of company like $311.8 billion for Microsoft) Step 4: Calculate Per Share Stock Value

Example Problem (CAPM and alpha)

T-Bills averaged 5% over last few years. S&P 500 averaged 15%. The ABC Fund had an average return of 14% and a beta of 0.80. What's the fund's expected return? CAPM Equation: E(Ri) = Rf + ßi * (Rm - Rf) -> Expected Return = 5% + 0.8(15% - 5%) = 13% ->Find ABC's alpha: Alpha = Observed Return - Expected Return Alpha = 14% - 13% = 1% *Outperformed by 1% (observed is larger than expected and number is positive) *On graph, plot above the risk line (Performance is important!)

Valuing a Bond - Non-Callable Premium Bond Example

The interest rates for a 10-year, 8% coupon bond with a face value of $1000 drops to 7%. What's its value at a semi-annual rate? N = 20 (semi-annual, 10 x 2 = 20) I/Y = 3.5% (7/2 = 3.5%, semi-annual) PMT = 40 ($1,000 bond for 10 years, so $100 per year with 8% is 100 x 0.8 = $80, $40 every 6 months) FV = 1000 Find PV which = $1071.06 *A bond in which its coupon rate is lower than the yield required by the market has a market price higher than its face value and is known as a Premium Bond*

Valuing a Bond - Par Bond Example

The yield for a 10-year bond is 8% and the coupon rate is 8%. We discount the cash flows at 8% semi-annually, so... N = 20 (10 x 2 = 20, semi-annual) I/Y = 4% (8 / 2 = 4%, semi-annual) PMT = 40 ($80 per year, $40 for 6 months) FV = 1000 (10 year maturity) Solve for PV which = $1000 (is the face value of the bond) *A bond in which its coupon rate is equal to its yield has a price equal to its face value and is known as a Par Bond*

Interest Rates, Default Risk, Other Factors and Bond Yields

The yield or return that an investor should expect to receive on a financial asset such as a bond is a function of a number of factors, the most important of which are: - The time value of money (treasury yield curve) - The default risk associated with a particular security - The liquidity premium and other bond specific factors peculiar to the financial asset, such as call provisions (convertibility or liquidity)

Types of Bonds and Trading Activity

Treasury Securities and the Treasury Market: -The market for U.S. Treasury securities is the largest and most liquid of any financial markets -Treasury notes have maturities of one-to-seven years, and bonds have maturities of over seven years -These securities pay interest on a semi-annual basis over the life the issue, and then the investor gets the principle back at maturity -Treasury securities' prices fluctuate daily in response to changes in interest rates and the economy