Investment Analysis & Portfolio Management

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Reilly Chapter 1: Overview of the Investment Process
❖ Investment: Current commitment of funds for a period of time to gain a future flow of
funds that compensates investor for time value of money, expected inflation rate over
investment period and a premium for uncertainty of future flow of funds.

Fundamental risks: Business, Financial, Liquidity, Exchange rate, Country/political

Characteristics of investment

Risk Return Safety Marketability

Purchasing
Liquidity Concealability Capital growth
power stability

Income
Tax benefit
stability

Formulae
Holding period (return): Time period of 𝑬𝒏𝒅𝒊𝒏𝒈 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
HPR= 𝑩𝒆𝒈𝒊𝒏𝒊𝒏𝒈 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
owing/holding investments (and earning
return for that time).
HPR > 1; Increase in wealth, positive return.
HPR < 1; Decline in wealth
HPR = 0; Lost all wealth
Holding period yield (HPY) HPR - 1
Annual HPR (AHPR) (𝑯𝑷𝑹)𝟏/𝒏
Arithmetic mean: Expected value for ∑HPY/n (Add all HPYs)
individual year.
Geometric mean: Best measure of long- (𝛑𝐇𝐏𝐑)𝟏/𝒏 − 𝟏 (Multiply all the HPRs)
term performance.

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Real risk-free rate (RRFR)/pure time (𝟏+𝑵𝑹𝑭𝑹)
−𝟏
(𝟏+𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝒓𝒂𝒕𝒆)
value of money: Basic interest rate,
assuming no inflation and no uncertainty
about future flows.
Nominal risk-free return (NRFR): {(1+ RRFR)*(1+ Expected inflation rate)} - 1
Prevailing market return determined by real
interest rate, expected inflation and monetary
environment.
Risk premium: Increase in required rate of Expected return- NRFR
return in excess of NRFR.

❖ Security market line (SML): Reflects the combination of risk and return available on
alternative investments.

Return
Movement along the line
means a change in risk of
an investment.

Risk

Return Demonstrates that investors want either higher

or lower return for the same risk.

Change in slope represents (or risk premium)

the change in the attitudes of investors towards
risk.
Risk

Return Shift in the SML reflects a change

New SML
in expected real growth, a change
in market conditions or change in
Old SML
the expected inflation rate.

Risk
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Reilly Chapter 4: Securities Markets- Organisations and Operations
❖ Market: Virtual/physical means through which buyers and sellers meet together for
exchange/transfer of goods/services. It doesn’t necessarily own the asset and can deal with
a variety of goods and services.

Characteristics of a good market

Timely and accurate

information

Price rapidly adjusts to

new information

Liquidity/marketability &
price continuity and depth

Low transaction cost

Three methods of municipal bond issues

• Competitive bid: Issuer is responsible for specifying the type of security to be offered,
timing etc. and then soliciting competitive bids from investment banking firms wishing to
act as an underwriter. The high bids will be awarded contracts.
• Negotiated pricing: Relationships are contractual arrangements between an underwriter
and the issuer where the underwriter helps the issuer prepare the security issue with the
understanding that they will have the exclusive right to sell the issue.
• Private placement: Sale of a bond issue by the issuer directly to an investor or small group
of investors.

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Types of new stock issues

Seasoned equity Initial public offering:

issues: New shares
offered by firms that
already have stocks
outstanding.
Involve a firm publicly
selling its common stock
for the first time.

Underwriter activities

Origination: Design of
the bond issue and
initial planning.
In negotiated bid, underwriter does all
Risk bearing: Acquires the 3 things. But in competitive bid, the
total issue competitive bid
price and resells it for price and other related thing is already
higher price.
set by issuer.
Distribution: Selling it
to investors.

Private placement and Rule 144A

Firm designs an issue with the assistance of an investment banker and sells it to a small group of
institution.

❖ Market order: Order to buy/sell a stock at the most profitable ask/bid prices existing at
the time of exchange.
❖ Limit order: Specifies a maximum purchasing price/minimum selling price of a stock.
❖ Short sale: Sale of stock that is not currently owned by the seller with interest of
purchasing it later at a lower price.
❖ Stop loss order: Conditional order where investors indicate that he wants to sell the stock
if price drops to a specified price. This is protection from larger and rapid decline in price.

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Reilly Chapter 5: Security Market Index
Use of security market index
• Index are used to derive market returns for a period of time and then used as a benchmark
for evaluating the alternative portfolios’ performance.
• Examine the relationship between market movements and changes in relevant variable to
find out the influence of market price of share.
• Used by technicians to predict future movements.
• A representative index is used as a proxy for the market portfolio of risky asset.

Differentiating factor between alternative market index

Sample of data

Source of information

Calculation method
(arithmatic/geometric)

Price-weighted series
❖ An arithmetic average of current prices of the securities included in the sample.
❖ DJIA: Best known and most popular stock market index which is the price-weighted
average of 30 large, well-known, industrial stocks who are the leaders in the industry. Used
most commonly for stock splits, price decline.

𝑫𝑱𝑰𝑨𝒕 𝑪𝒍𝒐𝒔𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒅𝒂𝒚 (𝒕)

𝑨𝒅𝒋𝒖𝒔𝒕𝒆𝒅 𝒅𝒊𝒗𝒊𝒔𝒐𝒓 𝒐𝒏 𝒅𝒂𝒚 (𝒕)

Value weighted index

❖ Begins by deriving the initial total market value of all stocks used in the series.

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Reilly Chapter 6: Efficient Market Hypothesis
❖ Efficient capital market: A capital market is efficient if the security prices adjust rapidly
to new (not known before/unpredictable) information. Therefore, current prices reflect all
available information. AKA informationally efficient market.

Why should capital markets be efficient?

• Profit-maximising investors and analysts are involved in analysis and valuation of stocks.
• Investor trading adjust security prices to reflect new information.
• New information has random, independent and unpredictable introduction into the market.

ECM requires minimum amount of trading and high volume of trading to allow faster price
adjustments. Price adjustments may be imperfect (over or under adjustment) but it is unbiased,
independent and random→ reflects true information.

Different market efficiencies for 2 stocks

Capital markets as a whole are efficient, but individual stock markets may not be efficient. Some
factors affect this.

• Number of analysts and volume of trading: Stocks with more analysts and well-
published information will jet adjusted faster to new information. But, smaller firm stocks
with fewer analysts and fewer sources of information will lead to slower adjustment to new
prices.
• Size of firm: Bigger firms→ more efficient; smaller firms→ less efficient

Alternative hypothesis
Random walk: Changes in the stock price occur randomly.

Fair game model: Current market prices fully reflect all available information, therefore the
expected returns based on the price also reflect risk.

Sub-hypothesis
Weak form EMH

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 • Current stock prices reflect all information in the security market such as historical
sequence of prices, rates of return, trading volume and other market-generated information.
• States that there is no relationship between past and future rates of return. Investors won’t
gain much using past information.
• Contradicts technical analysis (based on past info) because investor behaviour eliminates
profit opportunities based on stock price patterns.
• New information comes randomly, so stock prices are said to follow random walk.

Semi-strong form EMH

• Current prices adjust rapidly with release of new public information.

• Public information from market: Stock prices, rates of returns, trading volume.
• Public information from non-market: Earnings and dividends announcements, price
earnings ratio, dividend yield ratios, stock splits.
• Investors using new public information for decisions will earn average risk adjusted profits,
considering cost of trading.

Strong form EMH

• Current prices reflect information from public and private sources.

• Investors don’t have monopolistic access to information and won’t be able to consistently
earn above-average risk adjusted profits.
• Assumes perfect markets where all information is cost free and available to everyone at the
same time.

Implication of EMH for investments

Investors: Information is reflected quickly, investors can only get a normal rate of return. So,
awareness of information doesn’t do anything because of rapid adjustments.

Firms: Expect to get fair value of stocks they sell.

Corporate finance

• Price of company’s stock cannot be affected by change in accounting.

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 • Financial managers cannot “time” stock issue and bonds with publicly available
information.
• Firm can sell as many shares or bonds as they want without depressing prices.

Contradiction with fundamental and technical analysis

• Fundamental: Investment decisions can be taken by analysing economic and financial
variables to estimate intrinsic value of share.
• Technical: Opposes fundamentals by saying history repeats itself. Tries to estimate
intrinsic values by studying price movements.

EMH contradicts both of these because prices are instantly adjusted. But, continuous fundamental
and technical analysis keeps the market organised and efficient.

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Kevin Chapter 1: Introduction
❖ Portfolio management: Analysis of individual securities with theory and practice of
optimally combining securities into portfolios. Involves creation and maintenance of
investment portfolios ensuring more rewards and less risks.

Phases of portfolio management

Security Portfolio
P. Selection P. Revision P. Evaluation
analysis analysis

1st- Security analysis: Examines risk-return characteristics of individual stocks. Point is to buy
under-priced shares and sell over-priced shares through methods of identifying mispriced shares.

• Fundamental analysis: Works out intrinsic value using fundamentals of firm and industry (EPS,
dividend pay-out ratio, market share, management quality etc.) and compares with current market
value to determine (over/under) pricing.
• Technical analysis: Considers (systematic) share price movements to identify certain trends and
patterns.
• New EMH approach: Makes it possible for investors to earn normal returns with randomly
selected market securities.

2nd- Portfolio analysis: Identifying the range of possible portfolios that can be made from a set of
securities and calculating risk-returns for further analysis.

3rd- Portfolio selection: Finds the efficient portfolio (highest return with lowest risk). Markowitz’s
portfolio theory gives conceptual framework and analytical tools for choosing optimal portfolio
with discipline and objectivity.

4th-Portfolio revision: Purchase of new securities and sale of old securities as better stocks enter
market.

5th- Portfolio evaluation: Assesses performance of portfolio over a selected timeframe with given
risk level. Provides mechanisms for identifying weaknesses/deficits of investment which is
ongoing feedback for better construction of portfolio.

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Kevin Chapter 6: Risk
❖ Risk: Possible variations between actual return and expected return.
❖ Diversification of investment: Reducing unsystematic risk by combining stocks with
varying levels of suitable risk-returns.

Systematic Unsystematic
Economic/political/social
Firm-specific risk, Total
changes, interest rate risk,
market risk, purchasing power
business risk, risk
financial risk
risk

❖ Interest rate risk: Variation in bond prices due to variation in interest rates. Market price
of bond would increase when market interest rate is lower than coupon rate.
❖ Market risk: Variations in returns caused by stock market volatility.
❖ Purchasing power risk: Variation in investor returns due to inflation. (Demand pull
inflation→ increase in demand, unchanged supply. Cost push inflation→ Increase in cost,
increase in market price.)
❖ Business risk: Variability of operating income caused by operating conditions.
❖ Financial risk: Use of debt in capital structure.

Formulae
Return 𝑭𝒐𝒓𝒆𝒄𝒂𝒔𝒕𝒆𝒅 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 + 𝑭𝒐𝒓𝒆𝒄𝒂𝒔𝒕𝒆𝒅 𝒆𝒏𝒅 𝒐𝒇 𝒑𝒆𝒓𝒊𝒐𝒅 𝒔𝒕𝒐𝒄𝒌 𝒑𝒓𝒊𝒄𝒆
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
Expected return ∑𝑿𝒊𝑷𝒊
̅)
(𝑿
Variance (Ơ𝟐 ) ∑[𝑿𝒊 − ̅̅̅
𝑿]𝟐 𝑷𝒊
Standard √(Ơ𝟐 )
deviation (Ơ)

Measurement of systematic risk formulae

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Correlation: Beta is • 𝒓𝒊𝒎 = Correlation coefficient between return of i and return of
calculated using market index.
historical data of returns • Ơ𝒊 = Standard deviation of returns of i.
• Ơ𝒎 = Standard deviation of returns of market index.
𝒓𝒊𝒎 ∗ Ơ𝒊 ∗ Ơ𝒎 • Ơ𝟐 𝒎 = Variance of market returns.
𝜷𝒊 =
Ơ𝟐 𝒎
Regression: • n= Number of items
• X= Independent variable
Y= α + βX • Y= Dependent variable
̅ − 𝜷𝑿
α= 𝒀 ̅ • ̅ = 𝑀𝑒𝑎𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑋
𝑿
𝒏∑𝑿𝒀−(∑𝑿)(∑𝒀)
β= 𝒏∑𝑿𝟐 −(∑𝑿)𝟐
• ̅ = 𝑀𝑒𝑎𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑌
𝒀

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Kevin Chapter 7: Fundamental Analysis- Economy Analysis
Fundamental analysis includes three factors.

Economic
factors
EIC
Industry
factors
Analysis
Company
factors

Economic factors
• Growth rate of national income: GDP, GNP, NNP, estimated growth rate of the
economy/company is a pointer towards the prosperity of the economy.
• Four stages of economic cycle:

1. Depression (low demand, high 2. Recovery (demand picks up→ higher

inflation) investment)
3. Boom (high demand, investment and 4. Recession (downturn in demand,
production) production, employment and profit)

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• Inflation: Higher inflation→ costs rise→ profit margin decreases. Also leads to lower
purchasing power→ lower demand. Can be measured by Wholesale Price Index (WPI)
and Consumer Price Index (CPI).
• Interest rate: Low interest rate→ low production cost→ higher profitability.
• Government revenue, expenditure and deficits.
• Exchange rates: Affects imports and exports.
• Infrastructure: Development improves economy.
• Economic and political stability: Leads to steady and balanced growth.

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Kevin Chapter 8: Industry and Company Analysis
Industry life cycle

• Pioneering: Technology and product both are new, rapid growth of demand, fierce
competition, potential for profit, weak firms go out, investment is risky because low
profitability.
• Expansion: Firms develop own market and strategies, competition brings improved
products at lower prices, attractive for investment because high profitability, high return at
low risk because demand is higher than supply, higher dividends.
• Stagnation: Industry growth stabilises, sales are increasing at a slower rate, steady
profitability.
• Decay: No longer in demand, obsolete industry, no investments should be made because
no profitability.

Industry analysis
• Demand-supply gap: Demand changes steadily, supply changes irregularly. Excess
supply leads to decline in unit price (reduced profitability) . Insufficient supply leads to
higher unit price (increased profitability).
• Industry competitive conditions: Porter’s 5 Forces

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Barriers to entry
Threat of substitution
Bargaining power of buyers
Bargaining power of
suppliers
Rivalry among competitors
• Product differentiation: Buyers prefer to buy from
established firm.
• Absolute cost advantage: Established firms produce
at a lower cost.
• Economies of scale: Higher production level→ better
feasibility of cost.
Weak competitive position
Strong competitive position

• Labour conditions: Rebellious labour→ less progressive industry.

• Attitude of government: Positive attitude→ favourable regulations.
• Supply of raw materials
• Cost structures: Higher fixed costs→ higher volume needed for break-even→ lower
margin of safety.

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Company analysis
Deals with the risk-return characteristics of individual shares. This process uses information
from two sources.

Internal information: Public data
• Annual reports to shareholders
• Public and private statements of
officers
• Financial statements
External sources: Generated outside the firm
such as information prepared by investment
services and financial press.

Formulae
Ratio analysis

• Helps to determine strengths and weaknesses of a firm.

• Assesses whether financial performance and strength is improving or worsening.
• Can be used in comparative analysis with other firms and other time frames.

Liquidity Current ratio 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

Quick/Acid test ratio 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔−𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚−𝑷𝒓𝒆𝒑𝒂𝒊𝒅 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

Leverage Debt-equity ratio 𝑳𝒐𝒏𝒈−𝒕𝒆𝒓𝒎 𝒅𝒆𝒃𝒕

𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚

Total debt/Debt to total assets ratio 𝑻𝒐𝒕𝒂𝒍 𝒅𝒆𝒃𝒕

𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔

Proprietary ratio 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚

𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔

Interest coverage ratio 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙𝒆𝒔

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕

First three ratios show relative contribution of owners and creditors in financing company assets,
which reflect safety-margin for long-term creditors. Coverage ratio shows company’s ability to
meet interest payments from debt.

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Profitability- Sales Gross profit ratio 𝑮𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕
𝑺𝒂𝒍𝒆𝒔

Operating profit ratio 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙

𝑺𝒂𝒍𝒆𝒔

Net profit ratio 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙

𝑺𝒂𝒍𝒆𝒔

Admin. expenses 𝑨𝒅𝒎𝒊𝒏.𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔

𝑺𝒂𝒍𝒆𝒔
ratio
Selling expenses 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔
𝑺𝒂𝒍𝒆𝒔
ratio
Operating expenses 𝑨𝒅𝒎𝒊𝒏.+ 𝒔𝒆𝒍𝒍𝒊𝒏𝒈 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔
𝑺𝒂𝒍𝒆𝒔
ratio
Operating ratio 𝑪𝑶𝑮𝑺+𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔
𝑺𝒂𝒍𝒆𝒔

Profitability- Return on assets 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙

𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
Investment (ROA)
Return on capital 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙
𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
employed (ROCE)
Return on equity 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚
(ROE)
Profitability- Earnings per share 𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕 𝒂𝒗𝒂𝒊𝒍𝒂𝒃𝒍𝒆 𝒕𝒐 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔
𝑵𝒐.𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔
Equity shares (EPS)
Earnings yield 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

Dividend yield 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒕 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

Dividend pay-out 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒕 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
ratio
Price-earnings ratio 𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

Profitability- Return on investment 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙

𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
Overall (ROI) 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 𝑺𝒂𝒍𝒆𝒔
[ 𝑿 }
𝑺𝒂𝒍𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔

18
Activity/efficiency Current assets turnover 𝑺𝒂𝒍𝒆𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔
ratios 𝑺𝒂𝒍𝒆𝒔
Fixed assets turnover
𝑭𝒊𝒙𝒆𝒅 𝒂𝒔𝒔𝒆𝒕𝒔

Total assets turnover 𝑺𝒂𝒍𝒆𝒔

𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔

Inventory turnover 𝑺𝒂𝒍𝒆𝒔

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

Debtor’s turnover 𝑺𝒂𝒍𝒆𝒔

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒅𝒆𝒃𝒕𝒐𝒓𝒔

Risk assessment Degree of total leverage 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆−𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕

𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙
ratios (DTL)
Degree of operating 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆−𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙
leverage (DOL)
Degree of financial 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒕𝒔 𝒂𝒏𝒅 𝒕𝒂𝒙
𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙
leverage (DFL)

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Kevin Chapter 9: Bond Valuation
❖ Intrinsic value: The present value of all future amounts to be received against the share,
calculated with a discount rate.

Overpriced shares: Low intrinsic value, high market price→ Sell shares

Under-priced shares: High intrinsic value, low market price→ Buy shares

One-year holding period

𝑫𝟏 +𝑺𝟏 𝑫𝟏 = Expected dividend at the end of the year.
𝑺𝟎 = (𝟏+𝒌)𝟏
𝑺𝟏 = Selling price at the end of the year.
k = Rate of return

Multiple year holding period

𝑫𝟏 𝑫𝟐 𝑫𝒏 + 𝑺𝒏 𝑫𝒏 = Expected dividend at the end of n years.
𝑺𝟎 = + + ⋯ +
(𝟏 + 𝒌)𝟏 (𝟏 + 𝒌)𝟐 (𝟏 + 𝒌)𝒏 𝑺𝒏 = Expected selling price at the end of n
years.
Criticisms: Difficult to accurately predict dividends for longer intervals.

Dividend growth models

Dividend per shares grows in relation to growth in company earnings. Assumptions can be made
about growth patterns in relation to dividend and share prices.

Constant growth model (Gordon’s share 𝑺𝟎 = 𝑫𝟎 (𝟏+𝒈)

(𝒌−𝒈)
valuation)
Assumptions

• Dividends grow at constant rate.

• Discount rate is greater than growth rate.

Multiple growth model (2-stage) 𝑫𝟏 𝟐𝑫 𝒏 𝑫 𝑫𝒏 (𝟏+𝒈)

𝑺𝟎 = ((𝟏+𝒌)𝟏 + (𝟏+𝒌)𝟐 + ⋯ + (𝟏+𝒌)𝒏 ) + (𝒌−𝒈)(𝟏+𝒌)𝒏

Assumptions

• Future period is dividend into two different growth periods, one with varying growth and
another with constant growth.

20
Kevin Chapter 13: Portfolio Analysis
Expected return of portfolio
̅ 𝒑 = ∑ 𝒙𝒊 𝒓̅𝒊
𝑹 𝒙𝒊 = Weight of security
𝒓̅𝒊 = Expected return

Risk of portfolio
• Variance and standard deviation: Measure the extent to which returns are expected to
vary.
• Covariance: Measures the way security returns vary with each other, which affects overall
portfolio risk.
• Correlation coefficient: Standardised covariance.

̅ 𝒙 ) (𝑹𝒚 − 𝑹
∑(𝑹𝒙 − 𝑹 ̅ 𝒚) Positive: Return of 2 sticks move in the same
𝑪𝑶𝑽𝒙𝒚 = 𝑵
direction.
Negative: Return of 2 sticks move in the
opposite direction.
Zero: Movements are independent.
𝑪𝑶𝑽𝒙𝒚 -1: Perfect negative correlation
𝒓𝒙𝒚 = Ơ𝒙 Ơ𝒚
1: Perfect positive
𝑪𝑶𝑽𝒙𝒚 = 𝒓𝒙𝒚 ∗ Ơ𝒙 Ơ𝒚
0: Independent
There is no point in diversifying if there is perfect positive correlation in multiple stocks. But, if
there is negative correlation, risk can be reduced by diversification.

Portfolio variance for 2 securities

Ơ𝒑 𝟐 = (𝒙𝟏 𝟐 ∗ Ơ𝟏 𝟐 ) + (𝒙𝟐 𝟐 ∗ Ơ𝟐 𝟐 ) + (𝟐𝒙𝟏 𝒙𝟐 ∗ 𝒓𝟏𝟐 ∗ Ơ𝟏 Ơ𝟐 )

Portfolio variance for more than 2 securities

̅ 𝒑 = ∑ 𝒙𝒊 𝒓̅𝒊
𝑹
Ơ𝒑 𝟐 = ∑ ∑ 𝒙𝒊 ∗ 𝒙𝒋 ∗ Ơ𝒊𝒋

21
Kevin Chapter 14: Portfolio Selection
❖ Optimal portfolio: Portfolio with highest return and lowest risk.
❖ Portfolio selection: Process of finding optimal portfolio.
❖ Feasible set of portfolios/opportunity set: Total combination of stocks into a portfolio.
❖ Efficient set pf portfolios: Portfolios lying between the global minimum variance
portfolio and the maximum return portfolio on the efficient frontier.

Drawbacks of Markowitz’s model

• Large number of input data needed for calculation.
• Numerous, complex calculations.

Security risk and return

̅ 𝒊 = 𝜶𝒊 + 𝜷𝒊 𝑹
𝑹 ̅𝒎 𝜶𝒊 = Part of security i’s return independent of market
̅ 𝒎 = Rate of return on market index
𝑹
𝜷𝒊 = Expected change in 𝑅𝑖 given a change in 𝑅𝑚
(Risk)→ Ơ𝒊 𝟐 = 𝜷𝒊 𝟐 Ơ𝒎 𝟐 + Ơ𝒆𝒊 𝟐 Ơ𝒊 𝟐 = Variance of individual security
Ơ𝒎 𝟐 = Variance of market index returns
Ơ𝒆𝒊 𝟐 = Variance of residual returns

Portfolio risk and return

̅ 𝒑 = 𝜶𝒑 + 𝜷𝒑 𝑹
𝑹 ̅𝒎

𝜶𝒑 = ∑𝑾𝒊 𝜶𝒊
𝜷𝒑 = 𝑾𝒊 𝜷𝒊

(Risk)→ Ơ𝒑 𝟐 = 𝜷𝒑 𝟐 Ơ𝒎 𝟐 + ∑𝑾𝒊 𝟐 Ơ𝒆𝒊 𝟐

22
Kevin Chapter 15: Capital asset Pricing Model: (Sharpe et al., 1960’s)
Derives the relationship between expected return and risk of individual securities and portfolios,
if everyone behaved in the way the portfolio theory suggested.

Fundamentals
Investors try to reduce risk (variability of returns) through diversification and creating a portfolio.
Any number of portfolios may be created by changing the proportion of funds invested in each
security. Some are more efficient than others because of lower risk or higher returns. Higher the
risk of a security, higher the expected return.

Defining risks

❖ Market/systematic risk: Undiversifiable risk of variability because it affects all securities

in the market.
❖ Real/unsystematic risk: Market risk that cannot be diversified. Shows security’s
sensitivity to market movements, measured by beta coefficient.

Assumptions
• Investors decide with expected returns and standard returns of returns.
• Purchase/sale of security can be undertaken in indefinitely divisible units.
• Total investors’ actions determine prices in perfect competition, not single investors.
• No transaction costs and no personal income taxes.
• Tax rates on dividend income and capital gains are the same, so doesn’t matter which form
of return is received.
• Investors lend/borrow funds at interest rate of riskless securities.
• Investor can sell short any amount of any shares.
• Investors have similar expectations. Stocks have identical holding periods, expected
returns, variances of expected returns and covariances.

Efficient frontier
Investor faces an efficient frontier containing set of efficient portfolios of risky assets. A risk-less
asset is available where a return is certain e.g., government security and the variability of
return/risk is zero. Investing/lending occurs at risk-free asset’s rate of return Rf. Investor may

23
borrow at same risk-free rate Rf for investing in portfolio of risky assets as well as use his own
funds.

A= Optimal portfolio; Rm= 15%; Rf= 7%

Capital market line

The line formed by investors mixing market portfolio with risk-free assets is known as Capital
Market Line. The combinations will lie on the straight line of efficient frontier. Each security is
held in the proportion which the market value of security bears to the total market value of all risky
securities.

• Slope: Price of risk/ risk premium/excess return earned per excess unit of risk
• Slope X Sigma: Risk premium available for particular efficient portfolio.
• Intercept: Reward for time and waiting.
• Expected return= Price of time X (Price of risk X Amount of risk)

Security market line

Unsystematic risk becomes zero for a well-diversified portfolio. Leftover/systematic/relevant risk
is measured by Beta β.

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Risk-free asset has expected return Rf and beta coefficient zero. Market portfolio has expected
return of R⁻m and beta coefficient 1. Straight line joining these 2 points is the security market line.

• Rf: Reward for waiting

• Slope X beta: Risk premium available for security
• Expected return of security= Risk-free return + (beta X market risk premium)

Beta measures

Shows security’s sensitivity to market changes.

• Less than 1→ Lower sensitivity to market changes

• Equal to 1→ Movement at same rate and direction of market.
• More than 1→ Higher sensitivity to market changes

CAPM
Relationship between risk and return shown by the security market line is CAPM.

Simple linear relationship where higher beta shows larger risk and higher expected returns.

P→Beta= 0.7; Q→ Beta=1.6 R⁻i= Rf + β (R⁻m- Rf)

Risk-free rate= 6% =6 + 0.7 (15-6)
Market return= 15% =12.3 %
Market risk premium=9% R⁻i= Rf + β (R⁻m- Rf)
=6 + 1.6 (15-6)
=20.4 %

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Kevin Chapter 18: Portfolio Evaluation
❖ Portfolio evaluation (last stage of portfolio management): Examines how many objectives
have been achieved.
❖ Mutual funds: Professionally managed investment fund that pools money from different
investors to purchase securities.

Portfolio analysis, selection and revision→ taken to maximise returns and minimize risk.

Need for evaluation

Individual investments→ not enough funds, time, skill and resources for proper diversification
and management.

Institutional investor (mutual funds) and investment companies→ better equipped to deal and
manage diversified portfolios. Small investors trust funds with their money to get maximum
returns with minimum risk and effort. Reasons are:

• Self-evaluation: Individuals to portfolio performance evaluation to identify mistakes so

that next time can be improved for better performance.
• Evaluation of portfolio managers: Organisations do portfolio performance evaluation to
judge performance of all different portfolio managers.
• Evaluation of mutual funds: Investors want to know comparative performance of mutual
funds to select best one for investment.

Evaluation perspectives
• Transaction view: Evaluate every purchase and sale of securities to judge suitability and
profitability.
• Security view: At the end of holding period, market price of security maybe higher or
lower than cost. Interest or dividends can also be present. The profitability of separate
securities are evaluated.
• Portfolio view: Evaluate portfolio performance as a whole, this is where risks are best
defined.

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Functions of portfolio evaluation
• Profitability measurement: It is an accounting function. It measures return earned against
risk on portfolio during the holding period.
• Performance evaluation: Qualitative measures such as reasons of superiority and
inferiority of performance, extent of managerial skill etc.

Measures of portfolio return

Method 1: Simple returns

Changes in the portfolio value over holding period plus any incomes earned.

̅ 𝒑 = ∑ 𝒙𝒊 𝒓̅𝒊
𝑹 𝒙𝒊 = Proportion of funds invested in stock i.
𝒓̅𝒊 = Expected return of stock i.

Method 2: Mutual funds

Cash inflow and outflows occur during the holding period. Gives holding period yield/rate of
return earned as a %.

(𝑵𝑨𝑽𝒕 − 𝑵𝑨𝑽𝒕−𝟏 )+ 𝑫𝒕 +𝑪𝒕 𝑵𝑨𝑽𝒕 =NAV per unit at the end of holding period.
𝑹𝒑 = 𝑵𝑨𝑽𝒕−𝟏
𝑵𝑨𝑽𝒕−𝟏 = NAV per unit at the beginning of holding period.
𝑫𝒕 = Cash disbursements per unit during the holding period.
𝑪𝒕 = Capital gain disbursements per unit during the holding
period.

Method 3: Sharpe ratio

Rate of return/risk premium against the variability of return/risk measured by the standard
deviation of return.

𝒓𝒑 −𝒓𝒇
𝑺𝑹 = 𝒓𝒑 = Realised return on portfolio.
Ơ𝒑
𝒓𝒇 = Risk-free rate of return.

27
 Ơ𝒑 = Standard deviation of portfolio return.

Method 4: Treynor ratio

Rate of return/risk premium against the volatility of return/risk measured by the portfolio beta.

𝒓𝒑 −𝒓𝒇
𝑻𝑹 = 𝒓𝒑 = Realised return on portfolio.
𝜷𝒑
𝒓𝒇 = Risk-free rate of return.
𝜷𝒑 = Portfolio beta

Method 5: Jensen differential return

Measures differential between expected return and actual return earned on portfolio, with given
level of risk. Shows managers’ predictive skills.

❖ Differential (𝜶𝒑 ): Excess return that has been earned over what is mandated for this level
of systematic risk.

𝑬(𝑹𝒑 ) = 𝑹𝒇 + 𝜷𝒑 (𝑹𝒎 − 𝑹𝒇 ) 𝑹𝒇 = Risk-free rate.

𝑹𝒎 = Return on market index.
𝜷𝒑 = Systematic risk of portfolio.
𝜶𝒑 = 𝑹𝒑 − 𝑬(𝑹𝒑 ) Positive: Superior management skills and high returns
Zero: Neutral
Negative: Worse performance

28