Investment Returns, Equity Value,
and Financial Statements
PART I
Understanding investment
returns and how analysts’
styles are determined by their
approach to forecasting returns
Chapter 3
Understanding valuation
models that value forecasted
returns
Chapter 4
Understanding how earnings
are related to returns and how
valuations based on forecasted
earnings work (or don’t work)
Chapter 5
Understanding how forecasts
of income statements and
balance sheets produce a
valuation
Chapter 6
With this understanding proceed to
· Analysis of information (Part II)
· Forecasting and Valuation (Part III)
Gaining the Understanding to do
Fundamental Analysis
Chapter 3
Investment Returns
Investment Returns
Chapter 1 established that
forecasting returns is at the
heart of fundamental analysis
Link to Previous Chapter
This chapter explains what
returns are, distinguishes
normal and abnormal returns,
and explains how analysts
specialize in forecasting
normal and abnormal returns
This Chapter
Chapter 4 will show how
valuation models are
constructed to measure the
value of forecasted returns
Link to Next Chapter
Link to Web Page
How are
returns
calculated?
What is a
normal return
and an
abnormal
return?
How might an
analyst gain
an advantage
in forecasting
normal or
abnormal
returns?
What has been
the historical
experience in
equity
investing?
What you will learn in this chapter
• How investment returns are calculated
• The difference between normal and abnormal returns
• What an efficient market price means
• What an arbitrage opportunity is
• The difference between active and passive investment
• The difference between an alpha and a beta
• How asset pricing models work (in outline)
• How screening strategies work (and don’t work)
• What a contrarian strategy is
• How fundamental analysis differs from screening and
contrarian analysis
• How various stock selection strategies have worked in
the past
• For a terminal investment:
• For an investment in equity:
• For a one-year equity investment
4 Payoff:
4 Return:
4 Rate-of-Return:
4 Expected Return:
4 Expected Rate-of-Return:
4 Required Payoff per dollar:
4 Required Rate-of-Return:
The required return is also called the normal return or the cost of capital
The Structure of Investment Returns
d1 d2 d3 dT-1
1 2 3 T-1
0
T
P0
Investment Horizon:
When stock is sold
PT+dT
Dividend at T
Selling Price (if sold at T) +
Dividends
Initial Price
Hewlett-Packard: Returns for 1991
• If the price paid for a stock is
(expected payoff discounted at the required payoff per
dollar, r), the stock is appropriately priced: the market
price is efficient
• Or, price is efficient if it equals the expected return
capitalized at the required rate-of-return:
• Or, today’s price (P0) must be such that the required
rate-of-return, r-1, will equal the (expected) rate-of-
return :
The No Arbitrage Condition (NA)
Required
Rate-of-Return
Expected
Rate-of-Return
Arbitrage Trading Strategies
• If NA holds, the market is efficient in that stock: there
is no arbitrage opportunity
• Any discrepancy between expected and required rate-
of-return, is an arbitrage opportunity that, if
exploited, will profit the arbitrage trader
• An arbitrage opportunity arises if
If then BUY
If SELL
• The difference is called the expected abnormal return
and the rule can be restated as: BUY if the expected
abnormal return is positive, and SELL if negative. If it
is zero, do nothing (HOLD)
Types of Arbitrage
• Risk
1. Pure (Risk-Free) Arbitrage
You get something for nothing, for sure
2. Expectational Arbitrage
You have a better chance of an abnormal return than
not
• Location of prices
1. Cross-sectional Arbitrage
Different prices for the same commodity at the same
point in time
2. Intertemporal Arbitrage
Different prices for the same commodity at different
points in time
• These concepts apply to an investment for more than
one period with two modifications:
4 The multiperiod rate-of-return will be the compounded annual rate.
For a T-year period and a flat term structure, the required payoff is:
For a changing term structure it would be
4 Dividends for the intermediate years can be reinvested at r. The
accumulated value at year T of reinvested dividends is called
terminal value of dividends at T
4 Adding the selling price will give the cum dividend payoff or cum-
dividend terminal price:
4 And the T-period cum dividend return will be
Multiyear Equity Investments
Hewlett-Packard 1990-95: Payoffs
1994 19951993199219911990
d4= P5=84d3===
d5=
P0=13
Terminal Value of Dividends
0 1 2 3 4 5
d1 d2 d3 d4 d5
d2 x r
-2
d3 x r
-3
d4 x r
-4
d5 x r
-5
d1 r
-1
d2 r
-2
d3 r
-3
d4 r
-4
d5 r
-5
(Year 0 value) (Year 5 value)
1 2 3 4 5
d1 d2 d3 d4 d5
d4 x r
3 d x r
2
d2 x r
3
d1 x r4
d5
d4 r
1
d3 r
2
d2 r
3
d1 r
4
(Year 5 value)(Year 0 value)
0
( ) r-5
( ) r5
d t r
- t
t=1
5
å
HP 1990-95: Terminal Dividend Payoff
1990 1991 1992 1993 1994 1995
d92=
(1995 value)(1990 value)
d91= d93= d94= d95=
x
x
x
=
-5
=
1990 1991 1992 1993 1994 1995
(1990 value) (1995 value)
d92== d93= d94= d95=
x -5
x -4
x -3
x -2
=
5
=
HP 1990-95: Five-Year Return
Terminal value of dividends in 1995
Price payoff in 1995 (PT)
Total Payoff
Purchase price in 1990 (P0)
Five-year return
Five-year-rate-of-return %
*Normal rate of return (12% .) %
Abnormal rate of return %
* Normal rate of return = ( - 1) = %
• The NA condition for a multiyear investment is now
• Or
• Or
Multiyear Equity Investment: NA
Expected rate-of-returnRequired rate-of-return
Dividends and Capital Gains
T-period return components:
For one period:
Capital Gain
Component
Dividend
Component
+-
101 dPP
Capital Gain
Component
Dividend
Component
Intrinsic Values
• Intrinsic value is calculated by forecasting payoffs
from the information about them and applying the
discount rate
Two ways to calculate intrinsic values (V0):
1. Present value of the expected payoff
V0 = Expected payoff / rT
2. Capitalized expected returns
V0 = Expected returns / (rT -1)
Always two ingredients: Expected payoffs and discount rates
• Intrinsic values at different points in time always obey
the no arbitrage condition (NA):
=
• Beta technologies:
4 Calculates the normal return
4 Ignores any arbitrage opportunities
This is the denominator issue in valuation
• Alpha technologies:
4 Tries to gain abnormal returns by exploiting arbitrage
opportunities
This involves the numerator issue in valuation
Passive investment needs a beta technology (except for
index investing)
Active investing needs a beta and an alpha technology
Investment Advising: Alphas and
Betas
Beta Technologies:
“Asset Pricing Models”
Required return = Risk-free return + Premium for risk
Premium for risk = Risk premium on risk factors
x sensitivity to risk factors
Some technologies:
4 The Capital Asset Pricing Model (CAPM)
• One single risk factor: Excess market return over RF
Only “beta” risk requires a premium.
4 Multifactor pricing models
• Identify risk factors and sensitivities to them:
[ ] [ ]
[ ]
( )iFactorRisktoysensitiviti Factor Risk to turnReR
RR
RRRRRreturn Normal
ii
Fkk
F22F11F
=b=
-b+
+-b+-b+=
,
L
K
[ ]
FMF RRRreturn = Normal -b+
• Anticipates that a stock may be mispriced
Scenario A:
Today’s price deviates from its intrinsic value ,
but this will be corrected in the future ( ).
Scenario B:
Today’s price is correct , but in the future it will
deviate from its intrinsic value ( ).
• To discover these opportunities, a technology for
calculating intrinsic values is needed
Active strategies: Alpha technologies
V0
P0
PTC = VTC
1 2 3 4 T0
Normal return,
PTC
- V0
Abnormal return,
V0
- P0
Actual return,
PTC
- P0
Time
Cum-dividend
Value
VTC
P0 = V0
PTC
1 2 3 4 T0
Abnormal return,
PTC
- VTC
Normal return,
VTC
- V0
Actual return,
PTC
- P0
Time
Cum-dividend
Value
A Cheap Analysis: Screening
• Technical screens: identify positions based on trading
indicators. Some of them:
4 Price screens
4 Small stock screens
4 Neglected stocks screens
4 Seasonal screens
4 Momentum screens
4 Insider trading screens
• Fundamental screens: identify positions based on
fundamental indicators of the firm’s operations
relative to price
4 Price/Earnings (P/E) ratios
4 Market/Book Value (P/B) ratios
4 Price/Cash Flow (P/C) ratios
4 Price/Dividend (P/d) ratios
• Any combination of these methods is possible
Returns to Passive Investments
Technical Screening: Returns to Size
Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Size Groups
Returns to Beta: Is Beta Dead?
Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Beta Groups
Fundamental Screening: Return to
Price-to-Book
Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.
Returns to two fundamental screens
Year by Year Returns: Value minus
Glamour
Problems with Screening
• You could be loading up on a risk factor
4 You need a risk model
• You are in danger of trading with someone who
knows more than you
4 You need a model that anticipates future payoffs
A full-blown fundamental analysis supplies this
A P/V Ratio:
The Dow Stocks, 1979-98
Statistics Benchmark Dates
Mean September 1987:
StdDev .22 April 1993:
Max April 1994:
Min April 1995:
Mean+2 Std Dev = April 1996:
Mean-2 StdDev = April 1997:
April 1998:
THE P/V RATIO IS: (as of market close on December 4, 1998).
