penman  financial statements analysis and security valuation 5ed
LINKS
Link to previous chapters
Chapter 3 (and its
appendi
x
r
ev
iewed standard beta technologies
to measure the cost of
capital. Chapter
4
distinguished operating
ri
sk and
fin
an
ci
ng
ri
sk.
This chapter
This chapter analyzes the
fundamental determinants
of
op
erating a
nd
fin
ancing risk in equity
in
vesting. It
al
so outlines ways to
incorporate
ri
sk when
valuing firms and trading
in their shares.
Link to next chapter
Chapter
20
analyzes the
ri
sk
of
firms debt.
Link
to Web page
Go
to the text s Web site at
www
.mhhe.com/penman5e
for further
di
scussion
of
ri
sk.
The
Analysis
o
Equity
isk and eturn for
ctive
Investing
0 0
What are the What are the
Wh
at is price
How is
ri
sk problems with
fundamental
risk?
handled in
standard beta
determinants
of
active technologies?
ri
sk? investing?
Valuation involves both risk and expected return,
so
we
have referred to risk at many points
in this text. Risk determines an investor s required return, and expected payoffs must
cover the required return before an investment
can
be said to add value. As the book has proceeded, we have seen that, to value investments and
to
measure value added, expected payoffs must be discounted for
th
e required return. Indeed, Step 4
of
fundamental analysis
requires expected payoffs to be discounted using the required return to arrive at a valuation.
But
we
also have seen that valuations can be quite sensitive
to
estimates
of
the required return. In many applications
in
the book,
we
have estimated the required return using the
standard capital asset pricing model (CAPM). But
we
have done so with considerable dis
comfort because
of
problems
in
measuring the inputs into the model. Alternative multifac
tor models have been proposed (as discussed
in
the appendix
to
Chapter 3), but these beta technologies only compound the measurement problems. These models are speculative.
Socalled asset pricing models seemingly
do
not refer
to
fundamentals. They are composed
of
betas and risk premiums. Betas are defined by expected correlations between
Chapter
19
The
nalysis of Eq
t
y
Ri
s
a
nd
Ret
urn
for
Acti
ve
nvesting
64
After reading this chapter you should understand:
ã
The
difference between the required return and the
expected return. ã That precise
mea
sures
of
the cost
of
capital
are
difficult to calculate. ã How business investment
can
yield extreme
h
igh and low returns. ã How diversification reduces
risk.
ã Problems with
us
i
ng
the standard capital
asset
pricing model and other beta technologies. ã
The
fundamental determinants
of
risk.
ã
The
difference between fundamental
risk and
price r
isk.
ã How pro forma
analysis
can be
adapted to prepare valueatrisk profiles. ã
Ho
w the investor finesses the problem
of
not knowing the required return. ã How
to
be
sensitive to the
risk
associated with growth. After reading this chapter
you
should
be
able to: ã Identify a
firm s
risk
drivers. ã Generate a valueatri
sk
profile. ã Incorporate valueatrisk
analysis
in
stra
tegy formulation. ã
Deal
with the uncertainty about the required return.
ã Apply valueatrisk profiles to evaluate implied
ex
p
ec
ted returns estimated with r
everse
engineering. ã
Assign
firms
to
a
risk
class.
ã Carry
out
pairs trading. ã Estimate the expected return from buying a sto
ck
at the current
market
price. ã Generate
growthreturn
prof
iles.
ã
Engage
in
re
lative value investing and pairs trading.
ã Invest
wit
h a
margin of
safety.
investment returns and market returns, and risk premiums are defined
in
terms
of
expected returns. Typically betas and risk premiums are measured from past stock return
s
However,
risk, like return,
is
driven
by
the fundamentals
of
the
firm, the type
of
business it
is
engaged in, and its leverage;
in
short, a firm s operating
and
financing activities determine its risk. This chapter analyzes the fundamentals that determine
ri
sk, so that
yo
u can understand why
one firm would have a higher required return than another.
THE REQUIRED RETURN
ND
THE EXPECTED RETURN
The
required return
also referred
to as
the
cost
o
capital
is
the return
th
at an investor demands to compensate him for the risk he bears in making an investment. Both asset pric
ing models like the CAPM and the fundamental analysis
of
risk aim to determine what this required return should be.
f
markets are efficient, the market price will reflect this funda
mental risk: The price will be set such that the expected return
to
buying the shares will
equal the required return for risk.
This book, however, has entertained the notion that prices may not be efficient. That
is
, prices might be set
to
yield a return different from the required return that compensates for
risk.
f
the price
is
lower than that indicated by the fundamentals, the investor expects to
earn a return higher than the required return;
ifthe
price
is
set higher than that indicated
by
fundamentals, the
in
vestor expects a lower return than the required return. Active investors
attempt to identify such mispricing;
in
other words, they attempt
to
identify when the expected return
is
different from the required return. Hence,
we
distinguish the
expected return
from the required return. The expected return
is
the return from buying a share at
644 Part
Five
Tli
e A
nalys
is of
isk
and
R
et
urn
the current market price. The expected return is
equal
to the required return only
ifthe
market price
in
efficient. This chapter analyzes fundamental risk with
the
aim
of
determining the required return that compensates for that risk. But it also rejoins the earlier active investing analysis
of
Chapter 7 that determines the expected return.
That
analysis involves reverse engineering: Given forecasts
of
profitability and growth, what
is
the
expected return
to
buying at the cur
rent market price? The comparison
of
this implied expected return with the required return
indicates a buy, sell, or hold position.
Despite
an
enormous amount
of
research on
the
issue, measures
of
the required return (the cost
of
capital) remain elusive.
To
be blunt,
you
will not find a way
to
estimate the required return with assured precision in this
chapter.
You
will find the material here
to
be more qualitative than quantitative; the chapter will give you a feel for the risk you face but
will not transform that into a percentage return
number.
It is
just too much
to
think that risk can be reduced
to
one number like a beta. But the
expected
return
is
the focus
of
the active investor, so the chapter concludes with ways to
finesse
the difficulties
of
estimating the required return.
THE N TURE
OF RISK
Every year,
up
to
2007,
The
Wall
Street Journal
published a Shareholder Scorecard, which
ranked the
1,000
largest
U S
companies
by
market capitalization on their stock return perfor
mance. The year
2007
was a belowaverage year for stocks, with the S&P
500
stocks earning a retmn
of
5.5
percent. But there was considerable variation around this average. Table
19
.1
gives the top and bottom
Y
percent
of
performers
among
the
1,000
stocks that year. The historical average return to investing in
U.S.
equities has been about
12.5
percent per year. Table
19
. I
gives you some idea
of
how
actual
returns vary from average returns.
There is a chance
of
doing better than
12.5
percentvery much better
as
the best performers
in
the table indicateand a chance
of
losing one's shirt as the negative returns in the table indicate. This variation in possible
outcomes
is
the risk
of
investing. The investor's perception
of
this variation determines the return she requires for an
investmenthow much she will charge in
terms
of
required return to investand the
return required by investors
is
the firm's cost
of
capital.
f
no
variation
in
returns is expected, the investment
is
said to
be
risk free. So
the
required reh1rn for a risky investment
is
determined as Required
return=
Riskfree
return
Premium for risk United States government securities are seen as
risk
free, and the yields on these securities
are readily available. The difficult part
of
determining a required return
is
calculating the premium for risk.
The istribution
o
Returns
The set
of
possible outcomes and the probability
of
outcomes that
an
investor faces
is
referred to as the
distribution
o
returns
Risk models typically characterize return distributions in terms
of
probability distributions that
are
familiar in statistical analysis. A prob
ability distribution assigns to each possible outcome a probability, the chance
of
getting that outcome. The average
of
all outcomes, weighted
by
their probabilities, is the mean
of
the distribution, or the expected outcome. The investor
is
seen as having an expected return
but also
is
aware
of
the probabilities
of
getting outcomes different from the expected return.
And
the risk premium she requires depends on her perception
of
the form
of
the distribution around the mean.
Chapter
19
The Analysis
o
Equity Ri
sk
and
e
t
urn
for
Active I
nves
tin
g
645
T BLE
19.1
Best and Worst 2007 Stock
Return
Performance for the 1,000
Firms
in
The Wall Street Journal s
Shareholder
Scorecard
The Best Performers
The
Worst
Performers OneYear
One
Yea
r Company
Return,
Company
Return,
First Solar
795.2
Countrywide Financial
78.4
Onyx Pharmaceuticals
425.7
MBIA
74.1
Mosaic
341
.7
Ambac Financial Group
0.6
CF
Industries Holdings
330.0
Washington
Mutual
68.2
Terra
Industries
298.7
Pulte Homes
68.0
Sun
Power
250.8
Lennar
65.2
Intuitive Surgical
236.8
MGIC
In
vestment

63
.6
Foster Wheeler
181.1
Off
i
ce
Depot
63.6
AK
Steel
Holding
173.6
Advanced
Micro
Devices
63.
1
OwensIllinois
168.3
SLM
58.5
Bally Technologies
166
2
Sepracor
57.4
Priceline.com
163.4
KB
Home
56.7
GrafTech International
156
5
CIT
Group

55
.9
National Oilwell Varco
140.1
Centex
54.9
Chipotle Mexican Grill
136.6
Fir
st Horizon
Nat
ional
54.9
Amazon.com
134.8
Sovereign Bancorp
54.4
Jacobs Engineering Group
134.5
AMR
53.6
App
le
133.5
Liz
Claiborne
53.0
McDermott
International
132.1
National City
52.7
Alpha Natural
Resources
128.3
Lexmark International
52.4
MEMC Electronic Materials
126.1
Rite
Aid
48.7
GameStop
125.4
D.R
. Horton
48
.6
Consol Energy
124.2
Freddie Mac
48
.6
FTI
Consulting
121
.0
Moody's
48
.1
MGI Pharma
120.2
Micron Technology
48
.1
Note:
The
best performers
li
sted are percent
of
the total, as are the worst performer
s
Stock return includes cha
nges
in share prices, reinvestment ofdivldends, rights and
warrant offerings, and cash equivalents (such as stock received in spinoffs).
Source:
The
Wall
Street Journal,
February 25, 2008. Analysis performed
by
L.E.
K
Consulting LLC. Copyright 2008 by D
ow
Jones Co.
In
c
Reproduced with permission
of
Dow Jones Co.
In
c in
the format textbook via Copyright Clearance Center.
Figure
19
.
la
plots the familiar bellshaped curve
of
the
normal
distribution.
f
returns were distributed according to the normal distribution, approximately
68
percent
of
outcomes would fall within 1 standard deviation
of
the expected return (the mean) and
95
percent within 2 standard deviations,
as
depicted. The typical
standard deviation
of
annual returns among stocks
is
abo
ut
30 percent. So, with a mean
of
12.5
percent, we expect returns to
fa
ll
between
47.5
percent and
+72.5
percent exactly
95
percent
of
the time ifreturns follow a normal distribution. But look at Table
19.1.
The stocks listed there are 5 percent
of
the Shareholder Scorecard s
1,000,
that
is
,
2
z
percent with the best performance and
2
z
percent with the worst, so their returns are those outside
95
percent
of
outcomes. The top performers ha
ve
returns considerably greater than
72.5
percent. Most
of
the worst performers have
2007
returns below
4
7
5
percent. Far worse returns are not uncommon; in
2002,
for example,
al
I the bottom
2
z
percent
of
stocks had returns worse than
69
percent, in
2001
they a
ll
had returns
of
less than
66
percent, and in the year
of
the bursting
of
the bubble,
2000,
the
2
z
percent worst performers all returned less than 
7 4
percent. Even in a good year,