3.

Portfolio Management
3.1 Risk and Return
 Net return
Pt +1 + Dt +1
rt +1 = −1
Pt
Dt +1 Pt +1 − Pt
= +
Pt Pt
= income yield + capital gain/loss

• Income yield : cash payout

• Capital gain/loss: change in security price
 Expected versus Realized return
• At the start of the period, some variables are not
known, so we can calculate only expected return
E t [Pt +1 ] + E t [Dt +1 ]
Expected Return; E t [rt +1 ] = −1
Pt
Pt +1 + Dt +1
Realized Return; rt +1 = −1
Pt
• ‘Expected’ and ‘Realized’ returns are very different!!!
 Risk
• Risk is the possibility of events occurring that will impact the
achievement of an objective.
• An investment’s volatility measures its deviation – either
above or below – the investment’s expected outcome.
• Risk is uncertainty about the future
– Probability Distributions
– While stocks do better on average, investors know that in
any one year, stocks may do much worse
• Summarize risk through standard deviation, σ, a measure of
dispersion
– Using historical data
– Frequency Distributions (Histograms)
 Standard deviation
• If r1, r2, r3, …, rT, are yearly returns, first compute the
sample variance of the returns

– Using the sample mean

1 T
r = ∑ rt
T t =1
– Sample standard deviation is then
T
1
V[~
r ] = σˆ =
2
∑
T − 1 t =1
(rt − r ) 2
σˆ = σˆ 2

– Functions average(), var(), and stdev() in Excel

The Historical Tradeoff Between Risk and Return in Large
Portfolios, 1926–2004

Source: CRSP, Morgan Stanley Capital International and Global Financial Data.
Copyright © 2007 Pearson Addison-Wesley. All rights
reserved.

10-7
 Geometric Average
• We can define rGEO as the return that makes

(1 + rGEO ) = (1 + r1 )(1 + r2 )...(1 + rT )

T

• or
rGEO = [(1 + r1 )(1 + r2 )...(1 + rT )]
1/ T
−1

• Always lower than arithmetic mean.

• An excellent measure of past performance.
 Geometric versus Arithmetic Average
• Suppose two years ago you made an investment
and doubled your money. Then, last year you lost
50%.
• Arithmetic Mean:
1 − 0.5
rARITH = = 0.25
2
• Geometric Average:
rGEO = [(1 + 1)(1 − 0.5 )]1/ 2 − 1 = 0
• Geometric mean is used for past performance.
• Arithmetic mean used to predict future
performance.
3.2 Portfolio Theory
 Portfolio Choice

→ Investors like return

→ Investors do not like risk (we assume risk aversion)

How can an investor optimally allocate wealth across assets to

maximize expected return while being exposed to the least
amount of risk?
 Correlation – Key to Understanding
the Benefits of Portfolios
• Let’s consider UCLA – USC securities:
Probability UCLA Inc. USC Inc.
20% 25% 20%
30% 22% 20%
50% 16% 12%

• Notice that the returns tend to move together

• Covariance is a measure of co-movement
• Correlation lies between +1 (perfect positive
correlation) and -1 (perfect negative correlation)
The risk of a portfolio is smaller than the weighted
average of the risk of the securities in the portfolio:

13
 If you can only choose one stock?
• Most investors like expected return and dislike
uncertainty (risk aversion)

.B

µΑ .A .C

.D
σΑ σ
 Indifference Curves
µ
µ

B
B

A
A

σ σ

Very risk averse (steep) Risk neutral

But, there is no reason to restrict your portfolio to holding one

security, you could buy a combination of both
 Portfolio weights
• Fraction of wealth invested in different assets
– Fractions
– Add up to 1.0
– Usually denoted by ‘w’
– Weights can be negative.
• Example
– $100 in savings account at bank, $200 in IBM
• Total investment: $100+$200=$300
– Portfolio weights
• Savings account: $100/$300 = 1/3
• IBM: $200/$300 = 2/3
 Notation
• Portfolio weights
wx and wy (with wx+wy=1.0)
• Expected (mean) returns
µx=E(rx) and µy =E(ry)
• Variances of returns
σ2x =Var(rx) and σ2y =Var(ry)
• Covariance of returns
σxy = Cov(rx , ry) = ρxy σx σy
 Portfolio return and expected return
• Portfolio return (random)
– Dollar value at end of period (plus cash flows) divided
by dollar value at beginning of period
– Can be computed as average of returns on individual
securities weighted by their portfolio weights
rp = wx rx + wy ry

• Then the expected return on the portfolio is

µp = wx µx + wy µy
Remember from stats that E(aX+bY)=aE(X)+bE(Y)

18
 Portfolio variance
• The expected return is a weighted average of
the expected return on the assets in the
portfolio.
• But, the variance is not a weighted average. It
depends on how the returns on the assets in
the portfolio covary (correlation, covariance).
• Diversification can reduce the variance of a
portfolio.
 Portfolio variance
• The variance of a two-asset portfolio is
σ2p = wx2 σ2x + wy2 σ2y + 2wx wy σxy
σ2p = wx2 σ2x + wy2 σ2y + 2wx wy ρxy σx σy

Rem Var(aX+bY)=a2Var(X)+b2Var(Y)+2abCov(X,Y)

• The variance of an N-asset portfolio is

σ P2 = ∑ wi2σ i2 + ∑ ∑w w σ σ
i j i j ρij
i i j ≠i
 Two risky assets
• Two risky assets – bond and stock portfolios
– Means of 3.0% and 7.5%
– Standard deviations of 10% and 20%
– Correlation of 0.2
• Consider a portfolio with 1/3 of funds invested
in bond and 2/3 of funds invested in stock
portfolios

21
 Two risky assets
• Portfolio expected return
µp = 1/3 × 0.03 + 2/3 × 0.075
= 0.06 = 6.0%
• Portfolio variance= wx2 σ2x + wy2 σ2y + 2wx wy σxy σxy = ρσxσy
σp2 = (1/3)2 (0.1)2+(2/3)2(0.2)2+2 (1/3)(2/3)(0.2 × 0.1 × 0.2)
= 0.0207
• Portfolio standard deviation
σp =√0.0207
= 0.1438 = 14.38%
• What happens if the proportions change?
• What happens when the correlation changes?
22
Two risky assets when proportions change

return
100%
Asset Y

100%
ρ = 0.2
Asset X

Efficient Portfolios: upper part of the curve

Perfect Correlation?
σ P2 = wx2σ x2 + wy2σ y2 + 2wx wy ρσ xσ y
ρ =1
σ P2 = ( wxσ x + wyσ y ) 2
σ P = wxσ x + wyσ y

ρ = −1
σ P2 = ( wxσ x − wyσ y ) 2
σ P = wxσ x − wyσ y > 0
σ P = wyσ y − wxσ x > 0
wx σ y
σ P = 0 when =
wy σ x
 Two-Assets: Different Correlations

return
100%
ρ = -1.0 Asset B

ρ = 1.0
100%
ρ = 0.2
Asset A

Efficient Portfolios: highest expected return for a given σ

 Two Assets: Correlation Effects

• Relationship depends on correlation

coefficient
• -1.0 < ρ < +1.0
• The smaller the correlation, the greater the
risk reduction potential
• If ρ = +1.0, no risk reduction is possible
What would happen to your portfolio possibilities if you
combined many risky assets?

P ortfolio S et G enerated by Many R is k y A s s ets

E ffic ient F rontier IB M B MY MS F T GPS G IS NK E WS M K S WS

7.000%

6.000%

5.000%
E xpec ted R eturn

4.000%

3.000%

2.000%

1.000%

0.000%
0.000% 5.000% 10.000% 15.000% 20.000% 25.000%
V ola tility

27
 Correlation and Diversification
• The various combinations of risk and return available
all fall on a smooth curve.
• This curve is called an investment opportunity set
because it shows the possible combinations of risk
and return available from portfolios of these two
assets.
• A portfolio that offers the highest return for its level
of risk is said to be an efficient portfolio.
• The undesirable portfolios are said to be dominated
or inefficient.
 Diversification and Risk
• In a large portfolio, some stocks will go up in value
because of positive company-specific events, while
others will go down in value because of negative
company-specific events.
• Unsystematic risk is essentially eliminated by
diversification, so a portfolio with many assets has
almost no unsystematic risk.
• Unsystematic risk is also called diversifiable risk,
while systematic risk is also called nondiversifiable
risk.
Why does diversification work?

• Total Risk = Unique Risk + Market Risk

• Unique Risk → risk that can be eliminated by

diversification because many of the perils that surround a firm
are unique to the firm (idiosyncratic risk)
• Market Risk → risk that cannot be eliminated by
diversification because there exist economy-wide perils that
affect all firms (systematic risk)

30
Diversification and Portfolio Risk
 Portfolio Risk
In a large portfolio the variance terms are effectively
σ diversified away, but the covariance terms are not.

Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the
risk of individual securities.
 Systematic Risk
• The risk of a well diversified portfolio depends on
the market risk of the securities included in the
portfolio
• The reward for bearing risk depends only on the
systematic risk of an investment, not on the risk
that can be diversified away.
• So, no matter how much total risk an asset has,
only the systematic portion is relevant in
determining the expected return (and the risk
premium) on that asset.
 Market Risk is Measured by Beta
• If you want to measure the contribution of an individual
security to the risk of a well-diversified portfolio, it is no good
thinking about how risky that security is in isolation, you need
to measure its market risk, and that boils down to measuring
how sensitive it is to market movements. This sensitivity is
called beta (β).
• Stocks with β>1 amplify movements in market
• Stocks with 0<β<1tend to move in the same direction as the
market, but not so far.

β of the market is 1 (portfolio of all stocks, “average”)

Beta Risk : Consider monthly returns to the following
securities. Which is riskiest? Why?
Month Global Dynamo Vanguard
REIT Group Index
Jan-05 -28.26% 9.16% 7.32%
Feb-05 -3.03% 0.73% -2.47%
Mar-05 8.75% -0.29% 2.26%
Apr-05 -1.47% 2.21% 5.18%
May-05 -1.49% -1.08% 4.04%
Jun-05 -9.09% -0.65% -0.59%
Jul-05 10.67% 2.22% 9.01%
Aug-05 -9.38% 0.00% 1.86%
Sep-05 10.34% 1.88% -0.40%
Oct-05 -14.38% -7.55% -2.34%
Nov-05 -14.81% -12.84% 2.04%
Dec-05 -4.35% -1.70% 2.38%
Jan-06 -5.45% -15.21% -6.72%
Feb-06 5.00% 7.61% 1.27%
Mar-06 9.52% 1.11% 2.61%
Apr-06 -0.87% -0.51% -2.50%
May-06 0.00% 12.71% 9.69%
Jun-06 4.55% 3.32% -0.69%
Jul-06 3.48% 3.17% -0.32%
Aug-06 0.00% -14.72% -9.03%
Sep-06 -13.04% -1.91% -4.89%
Oct-06 0.00% -12.50% -0.41%
Nov-06 1.50% 17.26% 6.44%
Dec-06 -2.56% -8.53% 2.72%

35 Standard Deviation 9.231% 8.167% 4.606%

You want to add a little of either Global or Dynamo to
the index. Which is riskiest now?

36
Most of Global’s risk is unique and can be
diversified away:
15.00%

Global’s return is 0% even

10.00% though the market is up 9.69%

5.00%

0.00%
12/1/05 1/1/06 2/1/06 3/1/06 4/1/06 5/1/06 6/1/06 7/1/06 8/1/06 9/1/06 10/1/06 11/1/06 12/1/06
Market
Unique
-5.00%

-10.00%

-15.00%

-20.00%

37
Dynamo has much more market risk which
cannot be diversified away:
15.00%

Dynamo is up 12.71% even though

10.00%
the market is up only 9.69%

5.00%

0.00%
12/1/05 1/1/06 2/1/06 3/1/06 4/1/06 5/1/06 6/1/06 7/1/06 8/1/06 9/1/06 10/1/06 11/1/06 12/1/06
Market
Unique
-5.00%

-10.00%

-15.00%

-20.00%

38
 Beta or Marginal Volatility Matters!

• We must differentiate between the riskiness of a stock

held in isolation (when standard deviation is the
appropriate risk measure) versus the riskiness of a
stock when held in a well diversified portfolio (when
beta is the appropriate risk measure)
• It should not be at all surprising that the required rate
of return on a security depends on its marginal
volatility

39
Only market or systematic risk matters:

• Capital Asset Pricing Model (CAPM)

• A zero beta investment adds nothing to the risk of a well-

diversified portfolio → earns the risk free rate of interest

• β>1 characterizes an aggressive security → earns more than

the rate of return expected on the market

• β<1 characterizes a defensive security → earns less than the

rate of return expected on the market

40
3.3 The Capital Asset
Pricing Model
 Efficient Investments
Efficient Frontier

return Inefficient
Investments

σ
As we discussed, since investors want to minimize risk
and maximize return, they will not invest in portfolios that
are dominated on either dimension. This leads to an
Efficient Frontier.
 Market Equilibrium

return Optimal
Risky
Portfolio

rf

σ
If all investors have the same expectations about risk and return,
all investors will have the same CAL because they all have the
same optimal risky portfolio given the risk-free rate. This is the
Capital Market Line (CML).
 Market Equilibrium
Market

return
Portfolio

rf

σP
With the capital market line identified, all investors choose a
point along the line: some combination of the risk-free asset
and the common optimal risky portfolio. In equilibrium this
portfolio has to be the market portfolio M.
 Market Equilibrium
• If all investors have the same set of
expectations, they will choose the same
optimal risky portfolio. All investors will always
hold this portfolio. In market equilibrium,
demand will equal supply. This optimal risky
portfolio will then be the market portfolio, the
value-weighted portfolio of all risky assets.
• Then with borrowing or lending, the investor
selects a point along the CML, the Capital
Market Line.
 Intuition
• If everyone in the economy holds an efficient
portfolio, how should securities be priced so that
demand equals supply?
• If, for given expected returns, variances, and
covariances, no investor wants to hold Xerox, what
will happen?
– Price (and expected return) of Xerox needs to adjust
• Equilibrium
– Every investor is happy with her portfolio
– Supply of assets is equal to demand for assets
 Intuition
• Every investor solves the mean-variance problem
and holds a combination of risk-free asset and
portfolio of risky assets (tangency portfolio)
• With homogeneous expectations, tangency
portfolio is the same for all investors
• In equilibrium the sum of all investors’ desired
portfolios must equal the supply of assets
• Aggregate supply of asset is the market portfolio
• Market portfolio has to be the tangency portfolio
 The Market Portfolio
• Everybody will want to invest in Portfolio M and
borrow or lend to be somewhere on the CML
– Therefore this portfolio must include all risky assets (or
else some assets would have no demand)

• Because the market is in equilibrium, all assets are

included in this portfolio in proportion to their
market value
 The Market Portfolio
• Portfolio of all risky assets that exist in the economy
• Portfolio weights
N ×P
wMi = i i
∑
j
N ×P
j j

where Ni is the number of shares and Pi the market

price of company i
• Should really include all assets
– Real estate
– Human capital
 Market Indexes
• Report the value of a particular portfolio of
securities.
• Examples:
– S&P 500
• A value-weighted portfolio of the 500 largest U.S. stocks
– Wilshire 5000
• A value-weighted index of all U.S. stocks listed on the
major stock exchanges
– Dow Jones Industrial Average (DJIA)
• A price weighted portfolio of 30 large industrial stocks
 Investing in a Market Index
• Index funds – mutual funds that invest in the
S&P 500, the Wilshire 5000, or some other
index.
• Exchange-traded funds (ETFs) – trade directly
on an exchange but represent ownership in a
portfolio of stocks.
– Example: SPDRS (Standard and Poor’s Depository
Receipts) represent ownership in the S&P 500
 Capital Market Line

E(r)

CML
M
E(rM)
rf

σ
σM
 Capital Market Line
• The CML is a straight line with intercept rf and
slope equal to the Sharpe Ratio of the market
portfolio E[r ] − r
Slope =
M f

σM
• The equation for the CML
E[rM ] − rf
E[rE ] = rf + σE
σM
• The slope gives us the market price of risk in the
market.
Relationship between Risk and Return
• In the mid 1960 three economists Sharpe,
Lintner and Treynor showed that in a
competitive market the expected risk
premium on a security varies in direct
proportion to its beta (its measure of
systematic risk)
• The relevant measure of risk is the covariance
of the asset or portfolio with the market
(beta)
 CAPM
• Expected Return on the Market:
E[rM ] = r M = rf + Market Risk Premium

• Expected return on an individual security:

E[ri ] = r i = rf + β i × (r M − rf )

Market Risk Premium

σ iM
where β i = 2
σM
Relationship Between Beta & Expected
Return (Security Market Line)

Expected return
SML

E[rM ]
Slope = (E[rM ] − rf )

rf

1.0 β

E[ri ] = rf + β i (E[rM ] − rf )
Relationship Between Risk & Expected
Return

Expected
return
SML
13.5%
10%

3%

1.0 1.5 β
β i = 1.5 r f = 3% r M = 10%

r i = 3% + 1.5 × (10% − 3%) = 13.5%

The Capital Market Line
Security Market Line
 CML vs. SML
• The CML plots the relation between expected
returns and standard deviation
• The SML plots the relation between expected
returns and β
• All portfolios, whether efficient or not, must lie on
the SML but only efficient portfolios are on the CML
– Investments with the same mean return can have
different standard deviations, but must have the same β.
In other words,the only relevant measure of risk for
pricing securities is β (a measure of covariance with
market portfolio)
 Historical Volatility and Return for 500 Individual Stocks,
by Size, Updated Quarterly, 1926–2004

Unlike the case for large portfolios, there is no precise relationship between
volatility and average return for individual stocks. Individual stocks have higher
volatility and lower average returns than the relationship shown for large
portfolios.
 Portfolio Betas
(
r i = rf + β i r M − rf )
∑ w r = ∑ w r + ∑ w β (r
i
i i
i
i f
i
i i M )
i
(
− rf = rf ∑ wi + r M − rf )∑ w β
i
i i

(
r P = rf + β P r M − rf )
Beta of a portfolio is portfolio-weighted average of
individual assets
β P = ∑ wi β i
i

– Beta of a company is the value-weighted average of

the betas of its subsidiaries
• CAPM (SML) holds also for all portfolios
 Example
– Suppose the stock of the 3M Company (MMM)
has a beta of 0.69 and the beta of Hewlett-
Packard Co. (HPQ) stock is 1.77.
– Assume the risk-free interest rate is 5% and the
expected return of the market portfolio is 12%.
– What is the expected return of a portfolio of 40%
of 3M stock and 60% Hewlett-Packard stock,
according to the CAPM?
 Example
• Solution

∑ i xi βi =
βP = (.40)(0.69) + (.60)(1.77) =
1.338

rf + β (E[RPortfolio ] − rf )
E[Ri ] = i
Mkt

E[Ri ] =5% + 1.338(12% − 5%) =14.37%

 Estimating β with regression
σ iM
• In practice βi = 2
ˆ
σM
usually estimated using the regression in excess returns

ri ,t − rf ,t = α i + β i (rM ,t − rf ,t ) + ε i ,t
• Estimation issues
– Betas may change over time
– Don’t use data from too long ago
– Five years of weekly or monthly data is reasonable
– Use Data Analysis / Regression or Linest in Excel
 IBM example

rIBM ,t − rf ,t = 0.015 + 1.237(rM ,t − rf ,t ) + ε IBM ,t

Sample : 1997-2001 30%

25%
20%
Excess IBM return

15%
10%
5%
0%
-15% -10% -5% -5% 0% 5% 10%
-10%
-15%
-20%
Excess market return
 IBM example
• Assume riskfree rate of 3% and equity premium of
6%
• Expected return on IBM assuming CAPM is true is
r=3%+1.237*6%= 10.42%
• In valuation applications, 10.42% would be the
discount rate in the present value formula
– E.g. If you expect IBM’s price to be $50 in one year
and expect it to pay a dividend of $2, then the
current fair price should be
$(50+2)/(1+.1042)=$47.1
 Testing the CAPM
• Method 1:
– Take a large number of stocks
– Over some time period, e.g. 1975-1995, estimate
the beta for each of them
– Then look at the average return on each stock in
the subsequent period, say 1995-2015
– Do the average returns line up with measures of
beta?
 Testing the CAPM
• Method 2:
– Take a large number of stocks
– Over some long period, e.g. 1950-2015, estimate
alpha and beta for each of them by running an
excess return regression
– Are the alphas on average zero
– Can the alphas be predicted by any security
characteristic like firm size or past performance?
 Testing the CAPM: Results
• Mixed: results with both approaches
– Higher beta stocks do earn higher returns on
average, but not that much
– Low beta stocks have higher returns than the
formula predicts
– High beta stocks have lower returns than formula
predicts
• A number of stock characteristics explain
average returns better than beta
 Testing the CAPM: Results
• Fama French (1992)
– No relation between beta and average returns
once you control for:
• Size (market capitalization)
• Ratio of book value of equity to market value
– “Beta is dead!”
– Multifactor models
 Testing the CAPM: Caveat
• Roll Critique (1977)
– Market portfolio not observable
– Limits tests of CAPM
• Also,
– Still used widely in corporate finance and portfolio
management
– Convenient was to estimate expected returns
– Theoretically plausible and intuitive
 3.4 Equity Valuation
Readings: Berk and DeMarzo, Chapter 9.

Bruce Carlin 35000: Investments 29 / 50

The Basic Valuation Formula

The rate of return on a stock is defined by

D 1 + P1
r= −1
P0
or, rearranging,
D 1 + P1
P0 = .
1+r
Today’s price equals the PV of the expected dividend plus the PV of
the expected price at the end of the year, both discounted at the rate
of return r .
Therefore, if we have r , we can then determine what today’s price
should be given our forecast for the dividend and next year’s price.

Bruce Carlin 35000: Investments 30 / 50

The Basic Valuation Formula (cont’d)
In turn, P1 is given by:
D 2 + P2
P1 = .
1+r
Substituting this expression into our formula for today’s price gives
D1 D2 P2
P0 = + 2
+ .
1+r (1 + r ) (1 + r )2
In general, for any time T we have
T
Dt PT
P0 = ∑ t
+
(1 + r )T
t =1 (1 + r )

If we let T → ∞, the PV of the terminal price approaches zero, and

we obtain an expression entirely in terms of dividends:
∞
Dt
P0 = ∑ ( 1 + r )t
t =1

This is the basic PV formula for a stock.

Bruce Carlin 35000: Investments 31 / 50
The Basic Valuation Formula (cont’d)
The basic PV formula is not very useful in practice, as it involves
forecasting dividends over very long horizons. However, we can
simplify it if we are willing to make some assumptions on the growth
rate of dividends.
For example, if we assume that the expected dividend grows at a
constant rate g forever, the PV formula simplifies to

D1
P0 =
r −g

Notice that we could rewrite the above expression as

D1
r= +g
P0

This formula is sometimes used for estimating expected returns (it

was very popular before the development of the CAPM).
Bruce Carlin 35000: Investments 32 / 50
The Valuation of Firms in Practice
So far, we have developed two “extreme” valuation formulas:
– The exact “academic” formula: P0 = ∑t∞=1 (1Dt
+r ) t
* Requires dividend forecasts far into the future
D1
– The “back-of-envelope” constant growth formula: P0 = r −g .
* Too “crude” for complex companies; may not use all the information
that we could gather about a corporation.
In practice, financial analysts use elements of both. Let T be the
maximum number of years over which accurate forecasting of
financial statements is possible:
– Forecast financial statements over the next T years to estimate
dividends
– Then estimate a long-run dividend growth rate to calculate the firm’s
“terminal value” after T years
T
Dt 1 DT + 1
P0 = ∑ ( 1 + r ) t
+
( 1 + r ) T r −g
t =1

Bruce Carlin 35000: Investments 33 / 50

Example: Applying the Valuation Formulas

The constant growth formula should be applied with extreme care,

because firms and industries tend to have a life cycle: when they are
young they grow very quickly, but then the growth slows down and
they might eventually cease to grow or even shrink. If present growth
rates are not likely to continue, you should adjust the valuation
formula accordingly.
For example, suppose that ABC, Inc. paid a dividend of $4 per share
last year and that its beta is 1.5. Analysts are forecasting that ABC
will experience two years of abnormally high growth of 20% in
earnings and dividends, before settling down to a normal growth rate
of 5% in year 3 and beyond. The current interest rate is 6.4%. What
is the market price of ABC’s common stock? Assume that the
expected excess return of the S&P500 is 8.4%.
Similar calculation will be used in DCF model later in lecture.

Bruce Carlin 35000: Investments 34 / 50

Example: Applying the Valuation Formulas (cont’d)
The expected rate of return for ABC is obtained from the CAPM:

r = rf + (rm − rf ) β = 6.4% + (8.4%)(1.5) = 19%.

The expected dividends are

D1 = 4(1.2) = 4.80,
D2 = 4(1.2)2 = 4.8(1.2) = 5.76,
D3 = 5.76(1.05) = 6.048, and
Dt = Dt −1 (1.05) for t = 4, 5, . . .

0 1 2 3 4 5 ...

P0 4.80 5.76 5.76(1.05) 5.76(1.05) 2 5.76(1.05) 3 ...

Therefore,
4.80 5.76 1
P0 = 1.19 + 0.19−0.05 1.19 = 38.61.
Bruce Carlin 35000: Investments 35 / 50
Stock Prices and Earnings

Our basic stock price valuation formula relates the stock price to
expected dividends. However, one of the most commonly used
indicators of a stock’s value is its P/E ratio (that is, their ratio of
price to earnings per share).
– Some industries, like automotive, have very low P/E’s (about 5),
whereas other industries, like drugs, have high P/E’s (about 20).
– Does this mean that the drugs industry is overpriced?
In order to understand the relationship between price and earnings, let
us consider a firm with no debt and a fixed amount of stock
outstanding. Define
Dt = Dividends per share at date t (end of year t )
Et = Earnings per share at date t (end of year t )
It = New investment per share at date t (end of year t)

Bruce Carlin 35000: Investments 36 / 50

Stock Prices and Earnings (cont’d)

Firm's Financial Capital

Operations Manager It Markets

Et Dt

Since the earnings of the firm are either distributed to the

shareholders as dividends or reinvested into the firm, we have

Et = Dt + It ⇔ Dt = Et − It .

Substituting this cash flow identity into the basic valuation formula
(on page 31) gives
∞
Et − It
P0 = ∑ (1 + r )t .
t =1

Bruce Carlin 35000: Investments 37 / 50

Stock Prices and Earnings (cont’d)
Now assume that the firm without any new investment in the future
(I1 = I2 = · · · = 0) would generate earnings per share equal to
E = E1 each year for the indefinite future.
This means that, for a firm that will make new investments in the
future,
Et = E + ∆t ,
where, trivially, ∆t = Et − E .
Therefore, we have
∞ ∞ ∞
E + ∆t − It E ∆t − It E
P0 = ∑ (1 + r )t = ∑ (1 + r )t ∑ (1 + r )t = r + PVGO,
+
t =1 t =1 t =1
| {z }
PVGO

where PVGO represents the PV of growth opportunities (through

future investments).

Bruce Carlin 35000: Investments 38 / 50

Stock Prices and Earnings (cont’d)
A growth stock is properly defined as a stock for which the PVGO
accounts for a significant fraction of its price.
We can manipulate the formula on the previous page:
E P 1 PVGO 1 PVGO P0
P0 = + PVGO ⇔ 0 = + = +
r E r E r P0 E
 
P PVGO 1
⇔ 0 1− =
E P0 r
 
P0 1 PVGO −1
⇔ = 1−
E r P0

The “traditional” use of the inverse of the P/E ratio to obtain a

stock’s expected rate of return only works when PVGO = 0.
A high P/E ratio can be the result of low expected future returns (i.e.
low systematic risk), or of large growth potential (growth stocks).

Bruce Carlin 35000: Investments 39 / 50

The Method of Comparables

The method of comparables involves analyzing the accounting ratios

of similar companies and using them to compute the stock price of a
particular firm of interest.
This method proceeds as follows:
– Identify comparable firms that have operations similar to those of the
firm whose value is in question.
– Identify measures for the comparable firms in their financial statements
and calculate multiples for those measures at which the firms trade.
* earnings
* book value
* sales
* cash flow
– Apply these multiples to the corresponding measures for the firm of
interest to get that firm’s value

Bruce Carlin 35000: Investments 40 / 50

The Method of Comparables Example

Suppose that we gathered the following information in an effort to

value Firm C.
Company Sales Earnings Book Value Market Value P/S P/E P/B
Firm A $31,169 $846 $11,351 $40,835 1.3 48.3 3.6
Firm B $7,468 $346 $1,344 $10,542 1.4 30.5 7.8
Firm C $18,243 $1,460 $2,321 ? ? ? ?

From this, we can compute the following.

Average Multiple Firm C’s Number Firms C Valuation
Sales 1.35 x $18,243 = $24,628
Earnings 39.40 x $1,460 = $57,524
Book Value 5.70 x $2,321 = $13,230
Average $31,794

If Firm C has 2,543 shares outstanding, its stock price should be

$12.50 per share.

Bruce Carlin 35000: Investments 41 / 50

Problems with this method

Which firm is the best comparable?

Which metric is the best to use?
What should we do with such different answers?
Is there a circular argument? That is, if we use the market value and
metrics to value Firm C, what would happen if we did it for Firm A
and got a different answer?
This method is a widely used in finance, especially as a back of the
envelope calculation
Decent uses?
1 May be good for private or thinly traded firms without a reliable traded
price.
2 May be used by investment bankers to assess the price at which a firm
should price its IPO.

Bruce Carlin 35000: Investments 42 / 50

Discounted Cash Flows

The dividend models that we explored are not that helpful in valuing
stocks for companies that do not pay dividends.
Also, as just explained, we cannot rely on comparables to value stocks.
As such, we will now learn a commonly used method called
Discounted Cash Flows (DCF).
As we will see, we need to forecast future cash flows over a finite
horizon for which we have good information and then estimate a
terminal value.
As such, the expression at the bottom of slide is re-written as
T
Ct 1 CT +1
P0 = ∑ ( 1 + r ) t
+
( 1 + r ) T r −g
t =1

Bruce Carlin 35000: Investments 43 / 50

DCF Example

Using a firm’s financial statements, the historical free cash flows are
calculated on the next slide over the time period 2006-2010.
Recall from Lecture 2 that we can calculate free cash flow (FCF) as

FCF = (1 − τc )(Revenues − Expenses − Depreciation )

+Depreciation − CapEx − ∆NWC

According to the analysis, revenues have grown at 10% and costs at

5%.
Assume that the firm is all equity.

Bruce Carlin 35000: Investments 44 / 50

DCF Example

2006 2007 2008 2009 2010

Revenues 50,000 55,000 60,500 66,550 73,205
Costs 35,000 36,750 38,587 40,517 42,543
Depreciation 5,000 5,500 6,050 6,655 7,321
Pre-tax profit 10,000 12,750 15,863 19,378 23,342
Tax @ 34% 3,400 4,335 5,393 6,589 7,936
Net income 6,600 8,415 10,469 12,790 15,406
Plus Deprec. 5,000 5,500 6,050 6,655 7,321
CAPEX 7,500 8,250 9,075 9,983 10,981
∆NWC 350 368 386 405 425
Free cash flow 3,750 5,298 7,058 9,057 11,320

Bruce Carlin 35000: Investments 45 / 50

DCF Example

Now we are interested in determining the firm’s stock prices as of

January 1, 2011.
This requires a number of assumptions.
– Revenues increase at 10% for the next three years.
– Costs increase at 5% for the next three years.
– Depreciation remains at 10% of revenues, CAPEX at 15% of revenues,
and change in NWC at 1% of costs.
– The discount rate is 10%.
– There are 75,000 shares of stock outstanding.
– After three years, free cash flows grow annually at 2%.

Bruce Carlin 35000: Investments 46 / 50

DCF Example

2011E 2012E 2013E

Revenues 80,526 88,578 97,436
Costs 44,670 46,903 49,249
Depreciation 8,053 8,858 9,744
Pre-tax profit 27,803 32,817 38,444
Tax @ 34% 9,453 11,158 13,071
Net income 18,350 21,659 25,373
Plus Deprec. 8,053 8,858 8,744
CAPEX 12,079 13,287 14,615
∆NWC 447 469 492
Free cash flow 13,877 16,761 20,009
Discount Rate 0.909 0.827 0.751
Present Value 12,616 13,852 15,033

Bruce Carlin 35000: Investments 47 / 50

DCF Example

The PV of three years of cash flows is calculated as:

PV = 12, 615 + 13, 852 + 15, 033

= 41, 501

But we also have to consider the value of the firm after this
three-year period. This requires computation of a terminal value.

FCF2013 (1 + g ) 1 (20, 009)(1.02)(0.751)

TV = 3
=
r −g (1 + r ) .1 − .02
= 191, 668

Therefore, the total value of the firm is 233,168.

The stock price is $3.11 per share.

Bruce Carlin 35000: Investments 48 / 50

DCF Example

It is important to note that the terminal value accounts for much of

the firm’s valuation.
In turn, the TV depends critically on growth. If shocks to growth are
persistent, this can have great impact on the firm’s stock price.
Let us vary g and observe the change in the firm’s stock price:

1% = $2.80 6% = $5.86
2% = $3.11 7% = $7.70
3% = $3.50 8% = $11.38
4% = $4.03 9% = $22.40
5% = $4.76

Bruce Carlin 35000: Investments 49 / 50