CHAPTER 6: RISKS AND RATES OF RETURNS
Under such conditions,
 Portfolio - a collection of investment securities
 dollar return - the total dollars received from the
investment less the amount invested
 Although expressing returns in dollars is easy, two
problems arise: (size) of the investment, timing of
the Return
 rate of return calculation “standardizes” the return by
considering the return per unit of investment; the
most common measure of investment performance
 Risk - defined in Webster’s as “a hazard; a peril;
exposure to loss or injury; refers to the chance that
some unfavorable event will occur
 stand-alone risk - the risk an investor would face if
he or she held only this one asset
 No investment will be undertaken unless the
expected rate of return is high enough to
compensate the investor for the perceived risk of the
investment.
 Investment risk - the probability of actually earning
a low or negative return
 probability - the chance that the event will occur
 Probability Distribution - A listing of all possible
outcomes, or events, with a probability (chance of
occurrence) assigned to each outcome.
 Expected Rate of Return, kˆ “k-hat” - The rate of
return expected to be realized from an investment;
the weighted average of the probability distribution
of possible results.
 payoff matrix
 The tighter, or more peaked, the probability
distribution, the more likely it is that the actual
outcome will be close to the expected value, and,
consequently, the less likely it is that the actual
return will end up far below the expected return.
Thus, the tighter the probability distribution, the
lower the risk assigned to a stock.
 The tighter the probability distribution of expected
future returns, the smaller the risk of a given
investment
 Standard Deviation, sigma σ - a statistical
measure of the variability of a set of observations.
 The smaller the standard deviation, the tighter the
probability distribution, and, accordingly, the lower
the riskiness of the stock.
 Variance, σ2 - The square of the standard deviation.
 k_ t (“k bar t”) denotes the past realized rate of
return in Period t, and k_ Avg is the average annual
return earned during the last n years.
 Coefficient of Variation (CV) - Standardized
measure of the risk per unit of return; calculated as
the standard deviation divided by the expected
return; is a better measure for evaluating risk in
situations where investments have substantially
different expected returns.
 Risk Aversion- Risk-averse investors dislike risk
and require higher rates of return as an inducement
to buy riskier securities.
 the higher a security’s risk, the lower its price and
the higher its required return.
 Risk Premium, RP- The difference between the
expected rate of return on a given risky asset and
that on a less risky asset; the additional
compensation investors require for assuming the
additional risk
 Expected Return on a Portfolio, ˆkp -- The
weighted average of the expected returns on the
assets held in the portfolio.
 Realized Rate of Return, k_ - The return that was
actually earned during some past period. The actual
return (k_ ) usually turns out to be different from the
expected return (kˆ ) except for riskless assets.
 Correlation - The tendency of two variables to
move together.
 Correlation Coefficient, r - A measure of the
degree of relationship between two variables.
 On average, the correlation coefficient for the
returns on two randomly selected stocks would be
about _0.6, and for most pairs of stocks, r would lie
in the range of _0.5 to _0.7.
combining stocks into portfolios reduces risk but
does not eliminate it completely.
 The smaller the positive correlation coefficients, the
lower the risk in a large portfolio.
 Market Portfolio - A portfolio consisting of all
stocks.
 Diversifiable Risk - That part of a security’s risk
associated with random events; it can be eliminated
by proper diversification (lawsuits, strikes,
successful and unsuccessful marketing programs,
winning or losing a major contract) company-
specific, or unsystematic
 Market Risk - That part of a security’s risk that
cannot be eliminated by diversification (war,
inflation, recessions, and high interest rates)
nondiversifiable, or systematic, or beta
 Capital Asset Pricing Model (CAPM) - A model
based on the proposition that any stock’s required
rate of return is equal to the risk-free rate of return
plus a risk premium that reflects only the risk
remaining after diversification.
 Professors Harry Markowitz and William F. Sharpe –
developers of CAPM
 Relevant Risk - The risk of a security that cannot be
diversified away, or its market risk. This reflects a
security’s contribution to the riskiness of a portfolio.
 Beta Coefficient, b - A measure of market risk,
which is the extent to which the returns on a given
stock move with the stock market.
 average-risk stock - is defined as one that tends to
move up and down in step with the general market
as measured by some index
 the “market” - defined as a portfolio consisting of all
stocks
 Beta - measures a stock’s volatility relative to an
average stock; beta is the most relevant measure of
any stock’s risk.
 Market Risk Premium, RPM - The additional return
over the risk-free rate needed to compensate
investors for assuming an average amount of risk.
 Security Market Line (SML) - The line on a graph
that shows the relationship between risk as
measured by beta and the required rate of return for
individual securities.
 the greater the average investor’s aversion to risk,
then (a) the steeper the slope of the line, (b) the
greater the risk premium for all stocks, and (c) the
higher the required rate of return on all stocks
 interest - amounts to “rent” on borrowed money, or
the price of money
 the risk-free rate as measured by the rate on U.S.
Treasury securities is called the nominal, or quoted,
rate, and it consists of two elements: (1) a real
inflation- free rate of return, k*, and (2) an inflation
premium, IP, equal to the anticipated rate of
inflation.1
 The slope of the Security Market Line reflects the
extent to which investors are averse to risk—the
steeper the slope of the line, the greater the average
investor’s risk aversion.
 a recent study by Eugene Fama of the University of
Chicago and Kenneth French of Yale found no
historical relationship between stocks’ returns and
their market betas, confirming a position longheld by
a number of professors and stock market analysts
 Fama and French found two variables that are
consistently related to stock returns: (1) the firm’s
size and (2) its market/book ratio. After adjusting for
other factors, they found that smaller firms have
provided relatively high returns, and that returns are
higher on stocks with low market/book ratios.
 In the multibeta model, market risk is measured
relative to a set of risk factors that determine the
behavior of asset returns, whereas the CAPM
gauges risk only relative to the market return.
 Therefore, earnings volatility does not necessarily
imply investment risk.
 (1) Earnings volatility does not necessarily signify
risk—you have to think about the cause of the
volatility before reaching any conclusion as to
whether earnings volatility indicates risk. (2) Stock
price volatility does signify risk.
CHAPTER 3: ANALYSIS OF FINANCIAL
STATEMENTS
 Financial statements report both on a firm’s position
at a point in time and on its operations over some
past period
 From an investor’s standpoint, predicting the future
is what financial statement analysis is all about,
while from management’s standpoint, financial
statement analysis is useful both to help anticipate
future conditions and, more important, as a starting
point for planning actions that will improve the firm’s
future performance
 Financial ratios are designed to help one evaluate a
financial statement.
 Liquid Asset - An asset that can be converted to
cash quickly without having to reduce the asset’s
price very much.
 Liquidity Ratios - Ratios that show the relationship
of a firm’s cash and other current assets to its
current liabilities.
 Current Ratio - This ratio is calculated by dividing
current assets by current liabilities. It indicates the
extent to which current liabilities are covered by
those assets expected to be converted to cash in
the near future.
 Current assets normally include cash, marketable
securities, accounts receivable, and inventories.
Current liabilities consist of accounts payable, short-
term notes payable, current maturities of long-term
debt, accrued taxes, and other accrued expenses
(principally wages).
 Quick (Acid Test) Ratio - This ratio is calculated by
deducting inventories from current assets and dividing
the
remainder by current liabilities.
 Asset Management Ratios - A set of ratios that
measure how effectively a firm is managing its
assets.
 Inventory Turnover Ratio - This ratio is calculated
by dividing sales by inventories.
 Days Sales Outstanding (DSO) - This ratio is
calculated by dividing accounts receivable by
average sales per day; indicates the average length
of time the firm must wait after making a sale before
it receives cash; also called the “average collection
period” (ACP), is used to appraise accounts
receivable
 Fixed Assets Turnover Ratio - The ratio of sales to
net fixed assets; measures how effectively the firm
uses its plant and equipment
 Total Assets Turnover Ratio - This ratio is
calculated by dividing sales by total assets;
measures the turnover of all the firm’s assets
 Financial Leverage - The use of debt financing.
 (1) By raising funds through debt, stockholders can
maintain control of a firm while limiting their
investment. (2) Creditors look to the equity, or
owner-supplied funds, to provide a margin of safety,
so the higher the proportion of the total capital that
was provided by stockholders, the less the risk
faced by creditors. (3) If the firm earns more on
investments financed with borrowed funds than it
pays in interest, the return on the owners’ capital is
magnified, or “leveraged.”
 There are two reasons for the leveraging effect: (1)
Since interest is deductible, the use of debt lowers
the tax bill and leaves more of the firm’s operating
income available to its investors. (2) If operating
income as a percentage of assets exceeds the
interest rate on debt, as it generally does, then a
company can use debt to acquire assets, pay the
interest on the debt, and have something left
over as a “bonus” for its stockholders
 Debt Ratio - The ratio of total debt to total assets;
measures the percentage of funds provided by
creditors
 Times-Interest-Earned (TIE) Ratio - The ratio of
earnings before interest and taxes (EBIT) to interest
charges; a measure of the firm’s ability to meet its
annual interest payments; measures the extent to
which operating income can decline before the firm
is unable to meet its annual interest costs
 EBITDA Coverage Ratio - A ratio whose numerator
includes all cash flows available to meet fixed
financial charges and whose denominator includes
all fixed financial charges.
 relatively short-term lenders focus on the EBITDA
coverage ratio, whereas long-term bondholders
focus on the TIE ratio.
 A sinking fund is a required annual payment
designed to reduce the balance of a bond or
preferred stock issue. A sinking fund payment is like
the principal repayment portion of the payment on
an amortized loan, but sinking funds are used for
publicly traded bond issues, whereas amortization
payments are used for bank loans and other private
loans
 Profitability Ratios - A group of ratios that show the
combined effects of liquidity, asset management, and debt
on operating results.
 Profit Margin on Sales - This ratio measures net
income per dollar of sales; it is calculated
by dividing net income by sales.
 Basic Earning Power (BEP) Ratio - This ratio
indicates the ability of the firm’s assets to generate
operating income; calculated by dividing EBIT by total
assets; shows the raw earning power of the firm’s
assets, before the influence of taxes and leverage,
and it is useful for comparing firms with different tax
situations and different degrees of financial leverage.
 Return on Total Assets (ROA) - The ratio of net
income to total assets.
 Return on Common Equity (ROE) - The ratio of net
income to common equity; measures the rate of return on
common stockholders’ investment.
 Market Value Ratios - A set of ratios that relate the
firm’s stock price to its earnings, cash flow, and book value
per share; give management an indication of what
investors think of the company’s past performance
and future prospects.
 Price/Earnings (P/E) Ratio - The ratio of the price per
share to earnings per share; shows the dollar amount
investors will pay for $1 of current earnings.
 Price/Cash Flow Ratio - The ratio of price per share
divided by cash flow per share; shows the dollar amount
investors will pay for $1 of cash flow.
 Market/Book (M/B) Ratio - The ratio of a stock’s
market price to its book value.
 Trend Analysis - An analysis of a firm’s financial ratios
over time; used to estimate the likelihood of improvement
or deterioration in its financial condition.
 Du Pont Chart - A chart designed to show the
relationships among return on investment, asset turnover,
profit margin, and leverage.
 Du Pont Equation - A formula which shows that the
rate of return on assets can be found as the product of the
profit margin times the total assets turnover.
 equity multiplier - which is the ratio of assets to
common equity
 Firms that use a large amount of debt financing
(more leverage) will necessarily have a high equity
multiplier—the more the debt, the less the equity,
hence the higher the equity multiplier.
 Benchmarking - The process of comparing a particular
company with a group of “benchmark” companies.
 “Window Dressing” Techniques - Techniques
employed by firms to make their financial statements
look better than they really are.
