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penman - financial statements analysis and security valuation 5ed
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  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. So-called asset pricing models seemingly do not refer to fundamentals. They are composed 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 value-at-risk 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 value-at-ri sk profile. ã Incorporate value-at-risk analysis in stra tegy formulation. ã Deal with the uncertainty about the required return. ã Apply value-at-risk 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 growth-return 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 market 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 required 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 below-average 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 percent-very much better as the best performers in the table indicate-and 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 investment-how much she will charge in terms of required return to invest-and the return required by investors is the firm's cost of capital. f no variation in returns is expected, the investment is said to be risk free. So the required reh1rn for a risky investment is determined as Required return= Risk-free 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 distributions 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 distribution 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 One-Year 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 Owens-Illinois 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 bell-shaped 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,

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Jul 23, 2017
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