FIN 355 (25 and 26) - Summary of Topics Covered, Discussion of a Few Investing Approaches (module 7).pptx

FIN 355 Principles of Investments Summary of FIN 355 Topics, Discussion of Investing Approaches Lecture Preview Big-Picture Motivation: FIN 355 is a beginning investments class designed to introduce the equity and debt markets, how stocks are traded, common approaches for estimating stock value,...

FIN 355 Principles of Investments Summary of FIN 355 Topics, Discussion of Investing Approaches Lecture Preview Big-Picture Motivation: FIN 355 is a beginning investments class designed to introduce the equity and debt markets, how stocks are traded, common approaches for estimating stock value, basic bond calculations, and to provide some intuition and experience with the mathematical measures and concepts related to portfolio risk and return calculations as well as provide a brief introduction to options and futures. This final lecture will review some of the key ideas from these earlier lectures and then end by discussing how these ideas relate to some common investing approaches. Discussion Outline: • What are the key pieces of intuition, terminology, and ideas covered in the 7 modules of FIN 355? • How do these ideas relate to common investing approaches? Using concepts and intuition introduced in FIN 355, what are the upsides and risks associated with these approaches? What are the underlying assumptions that must exist for these approaches to work? Overview of Investment Alternatives Financial Markets and Asset Classes Traditional Assets (exchanges, calls, puts, payoff diagrams) Bonds Stocks Alternative Asset Classes Options Market Bond Market Commodities Market (government vs corporate, ratings, risk-free rates) (exchanges, forward contracts) Hedge Funds Venture Capital Private Equity Stock Market FOREX Market (exchanges, accounts, shares, funds, indices) (currencies, exchange rates) Real Estate Commodities Overview of Investment Alternatives Financial Markets and Asset Classes Traditional Assets (exchanges, calls, puts, payoff diagrams) Bonds Stocks Alternative Asset Classes Options Market Bond Market Commodities Market (government vs corporate, ratings, risk-free rates) (exchanges, forward contracts) Hedge Funds Venture Capital Private Equity Stock Market FOREX Market (exchanges, accounts, shares, funds, indices) (currencies, exchange rates) Real Estate Commodities FIN 355 FIN 355 Course Outline Module 1 2 3 4 5 6 7 Lecture Topics Assignments Introduction to Debt and Equity Markets HW 1, 2 Risk and Return, Correlation, Standard Deviation, CAL (Midterm 1) HW 3, 4 Portfolio Theory, Diversification, Efficient Frontier HW 5 Risk-return Models, Betas (Midterm 2) HW 6 Security Analysis and Valuation HW 7, 8 Derivative Markets HW 9 Business Cycles, Inflation, Efficient Markets, Investing Approaches (Final Exam) HW 10, 11 FIN 355 Course Outline Module 1 2 3 4 5 6 7 Lecture Topics Assignments Introduction to Debt and Equity Markets HW 1, 2 Risk and Return, Correlation, Standard Deviation, CAL (Midterm 1) HW 3, 4 Portfolio Theory, Diversification, Efficient Frontier HW 5 Risk-return Models, Betas (Midterm 2) HW 6 Security Analysis and Valuation HW 7, 8 Derivative Markets HW 9 Business Cycles, Inflation, Efficient Markets, Investing Approaches (Final Exam) HW 10, 11 Module 1: Introduction to debt and equity markets  Financial assets have value because they lay claim to cash flows generated by real assets. • In your accounting class you learned that Assets = Debt + Equity. • The items listed on the left side of the balance sheet generate the current and future cash flows at the firm. The items listed on the right side are contracts that lay claim to those cash flows. • The value of the claims (right side) equal the value generated by the assets (left side). Market Value Balance Sheet Assets (e.g., property, equipment, etc.) Debt (e.g., bonds) Equity (e.g., common stock, preferred stock) Module 1: Introduction to debt and equity markets  The value (price) of a financial asset (e.g., a bond or share of stock) is the present value of the expected cash flows tied to the financial asset. Today’s Stock Price = PV (expected cash flows to stockholder) Today’s Bond Price = PV (expected cash flows to bondholder) Debt and equity contracts have different characteristics that affect their risk. • Debt contracts tend to have fixed claims on cash flows that have higher priority than equity claims. This is why debt tends to be less risky (lower variability in returns) and to have lower average returns across time than equity. • Equity holders are residual claimants. • Debt contract cash flows tend to be based on set calculations whereas equity cash flows are determined by the residual earnings in each period. Module 1: Introduction to debt and equity markets  Examples of debt and equity instruments discussed in FIN 355 Money market debt securities T-Bills Certificates of deposit Commercial paper Bankers’ acceptance Eurodollar bonds Fixed income debt securities Treasury notes and bonds TIPs Municipal bonds (“munis”) Corporate bonds Equity securities Common shares Preferred shares ADRs Debt and equity contracts have different characteristics that affect their risk and return. Module 2: Risk and Return, Correlation, Standard Deviation, CAL  Total risk can be measured using calculations based on the dispersion in outcomes such as standard deviation () and variance (). The center of a symmetrical return distribution is . To estimate the variance of a sample, (1) first calculate the sample average (“r-bar”), (2) then calculate how far each observation is from the average (), and (3) then add together all the squared deviations and divide by n - 1. Intuitively the variance is the average squared deviation from the mean. Example sample of returns: 0.10, 0.05, 0, -0.03  = .03 =.00327 Module 2: Risk and Return, Correlation, Standard Deviation, CAL  Different types of investments have different amounts of total risk. In general equity investments in smaller firms tend to have relatively high volatility in returns. The chart shows the distribution of annual returns for Treasury Bills, Corporate Bonds, U.S. Large Stocks (S&P 500) , Small Stocks across many years. In general, debt investments tend to have lower volatility in returns.  The standard deviation in historical returns for an asset class can help us understand how much we can lose if we were to invest in that asset class going forward. The future may not be exactly like the past. Modules 1 and 2:  Historical perspective on risk and returns What kinds of returns are typical of these types investments? … • Savings accounts (small to zero returns) Ave Annual Return Standard Deviation Worst Year's Return Best Year's Return • CDs (higher than savings accounts) • Short and/or long-term debt securities (short-term returns are generally small, returns depend on risk in the security with some debt contracts offering higher yields) • Government and/or corporate debt securities (government bonds tend to have lower yields than corporate debt) • Equity (common stock, preferred stock, ADRs) (on average higher returns than debt, residual cash flows are more volatile) • S&P 500 (average annual returns above 10% with a standard deviation of almost 20%) S&P500 11.51% 19.60% -43.84% 52.56% Baa Corporate Bonds 6.96% 7.80% -15.68% 29.05% US T-bill 3.32% 3.02% 0.03% 14.04% Annual Returns Over Time, 1928-2022 45% 30% 15% 0% -15% -30% -45% 28 33 38 43 48 53 58 63 68 73 78 83 88 93 98 03 08 13 18 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 S&P 500 3-month T-Bill Baa Corporate Bond Module 1: Introduction to debt and equity markets  Stocks are typically traded in the US via the NYSE or the Nasdaq. Retail investors tend to enact their trades via online brokerage accounts. • The “market” is typically open Monday – Friday from 9:30am – 4pm Eastern time. • Electronic computer networks (ECN) also allow stock trading for a few hours before and after the market is open but the liquidity and transparency is less on the ECNs than on the exchanges. Module 1: Introduction to debt and equity markets  Private firms become public firms at the time of the IPO. Public firms have more standardized requirements for financial reporting. • The IPO process is facilitated by investment banks. • A preliminary prospectus (red herring) is used during the road show to help advertise the firm’s upcoming offering and to help refine the price at which the new securities will be offered. If the offering has indication of high demand leading into the IPO the offer price can be higher than the initial price suggested during the road show. • On average, the share price at close of trading on the first day is 20-40% higher than the initial offer price. (“underpricing”) • Public firms can issue additional shares (SEO) or repurchase shares. Module 1: Introduction to debt and equity markets  Investors can trade stocks using market or price-contingent orders. Investors can go long or short in their investments. Investors can buy on margin. • Market order : buy or sell at the current ask and bid prices • • • • Limit buy order: buy if the security trades below a specific price Limit sell order: sell if the security trades above a specific price Stop-loss order: sell if the security trades below a specific price Stop-buy orders: buy the security if it trades above a specific price Short sale: the investor borrows the stock from the broker and sells it. Later, to “cover the short position” the investor then buys a share of the same stock in the market and gives it to the broker. Module 1: Introduction to debt and equity markets  Stock indices are easy ways to track the overall performance in a stock market. There are indices all across the world. We spent most of our time talking about the Dow Jones Industrial Average Index (DJIA) and the Standard & Poor’s Composite 500 Index (S&P500). • 30 vs 500 • Price- vs value-weighted If the index goes up this means the aggregate value of the firms within the index has gone up. Various sponsors have created funds based on the indices to allow investors to invest in portfolios that mimic the indices. Module 2: Risk and Return, Correlation, Standard Deviation, CAL  There are different ways to measure and summarize returns. • Annualized returns: APRs, EARs 1 + EAR = • Gross vs Net Returns P1 / P 0 vs (P1 - P0) / P0 • Arithmetic vs Geometric averages Arithmetic average = Module 2: Risk and Return, Correlation, Standard Deviation, CAL  In traditional portfolio theory we make 2 assumptions about investor preferences. The Sharpe ratio provides a measure that combines information related to both assumptions. All else equal, people prefer investments with higher expected returns.  The plots that show CALs help us see the E[r] and of different portfolios. A higher return corresponds with vertical movement in the plot. A lower risk corresponds with a leftward movement in the plot.  CALs touch the y-axis at the risk-free rate.  The slope of the CAL is the Sharpe ratio. Portfolio Expected Return All else equal, people prefer investments with lower risk. 0.25 Vanguard CAL Client's Current Mosaic CAL New Portfolio Portfolio 0.20 0.15 0.10 0.05 0.00 Vanguard and Bonds 100% Mosaic 0 0.1 0.2 0.3 Mosaic and Bonds 100% Vanguard 0.4 0.5 0.6 Portfolio Standard Deviation 0.7 Module 2: Risk and Return, Correlation, Standard Deviation, CAL  In traditional portfolio theory we make 2 assumptions about investor preferences. The Sharpe ratio provides a measure that combines the 2. All else equal, people prefer investments with higher expected returns.  The CAL traces out the portfolios that can be created using different investment weights with 1 risk-free and 1 risky asset.  Each portfolio can be described using an E[r] and formula that require investment weights. If there is only 1 risky asset in the mix… E Portfolio Expected Return All else equal, people prefer investments with lower risk. 0.25 Vanguard CAL Client's Current Mosaic CAL New Portfolio Portfolio 0.20 0.15 0.10 0.05 0.00 Vanguard and Bonds 100% Mosaic 0 0.1 0.2 0.3 Mosaic and Bonds 100% Vanguard 0.4 0.5 0.6 Portfolio Standard Deviation 0.7 FIN 355 Course Outline Module 1 2 3 4 5 6 7 Lecture Topics Assignments Introduction to Debt and Equity Markets HW 1, 2 Risk and Return, Correlation, Standard Deviation, CAL (Midterm 1) HW 3, 4 Portfolio Theory, Diversification, Efficient Frontier HW 5 Risk-return Models, Betas (Midterm 2) HW 6 Security Analysis and Valuation HW 7, 8 Derivative Markets HW 9 Business Cycles, Inflation, Efficient Markets, Investing Approaches (Final Exam) HW 10, 11 Module 3: Portfolio Theory, Diversification, Efficient Frontier  If you combine more than 1 risky asset together in the same portfolio, the formula for the portfolio E[r] is still a weighted sum but the formula for the risk changes. The return to a portfolio of assets is an average of all of the assets’ returns, weighted by the relative amount invested in each asset. Assuming 2 risky assets… E The weighted average intuition that applies to the Eequation does NOT apply to the equation. For example, the risk in a portfolio of 2 risky assets is NOT the average risk of all the assets weighted by the relative amount invested in each stock. Assuming 2 assets… Module 3: Portfolio Theory, Diversification, Efficient Frontier  Each asset’s returns move up and down over time in ways that are unique. If you combine unique assets together in the same portfolio their return movements cancel. Key Observations:  Months  +  Combining assets together in a portfolio results in a reduction in risk (diversification). This plot shows how the blue asset experiences positive returns in the same months that the green asset experiences negative returns. If an investor invested 50% in each asset the portfolio’s returns would have zero dispersion as shown by the dark black line. Module 3: Portfolio Theory, Diversification, Efficient Frontier  Diversification mitigates the effects of idiosyncratic risk on portfolio returns but does nothing to eliminate market risk. The total risk (variance or standard deviation) in any individual investment can be broken down into two sources. Some of the risk is idiosyncratic to the firm whereas the rest of the risk is systematic and affects all investments. Different textbooks use different terms: • Systematic • Market • Non-diversifiable Different textbooks use different terms: • Idiosyncratic • Firm-specific • Unique • Diversifiable Module 3: Portfolio Theory, Diversification, Efficient Frontier  Total risk can be divided up into 2 types of risk: firm-specific and market. There are various synonyms for these words. Firm-specific risk can be eliminated in a portfolio. Idiosyncratic risk is easily eliminated by diversifying your portfolio. • • If investors can’t easily eliminate market risk then investors need to be compensated for bearing market risk. If investors can easily eliminate idiosyncratic risk then investors don’t need to be compensated for this risk because they can diversify it away.  This suggests that total risk () may be too noisy of a measure for risk in models that predict returns if only a portion of it is compensated in the markets.  The CAPM formula suggests there is a relation between market risk and returns. Module 3: Portfolio Theory, Diversification, Efficient Frontier  If you combine more than 1 risky asset together in the same portfolio, the formula for the portfolio E[r] is still a weighted sum but the formula for the risk changes. Assume there are 2 risky assets (s, b) and 1 risk-free asset. One risky asset in portfolio: If , where ws and wf are constants, and is a random variable, then Two risky assets in portfolio: If , where ws and wb are constants, and both and are random variables and is the correlation in the return series, then + +, Module 3: Portfolio Theory, Diversification, Efficient Frontier  If you combine multiple risky assets together in the same portfolio, the risk in the portfolio can be decreased. This is the upside to diversification. Here is the formula for the variance in a portfolio with 3 risky assets (s, b, x). These 3 terms account for the stand-alone risk in the 3 risky assets + Accounts for how s and b move together or move opposite Accounts for how x and s move together or move opposite Accounts for how b and x move together or move opposite Module 3: Portfolio Theory, Diversification, Efficient Frontier  Specific investment weights can be used to reduce risk. In the table below each of the portfolios is created using the same 2 underlying assets. + Each row in this table uses the 2 formulas above but with different investment weights  On the next slide the frontier is traced out by plotting the x () and y (E[r]) values in this table. Portfolios 8, 9, and 10 will appear the furthest left (lowest risk). Labels 0 1 2 3 4 5 6 7 8 9 10 11 12 E[r] stdev corr Weights w[A] (1-w)[B] -0.1 1.1 0 1 0.1 0.9 0.2 0.8 0.3 0.7 0.4 0.6 0.5 0.5 0.6 0.4 0.7 0.3 0.8 0.2 0.9 0.1 1 0 1.1 -0.1 Asset A 0.17 0.2 0.1 Asset B 0.2 0.36 E[rp] 0.203 0.200 0.197 0.194 0.191 0.188 0.185 0.182 0.179 0.176 0.173 0.170 0.167 Var[rp] 0.156 0.130 0.107 0.087 0.070 0.057 0.046 0.039 0.034 0.033 0.035 0.040 0.048 Stdev[rp] 0.395 0.360 0.327 0.295 0.265 0.238 0.214 0.196 0.185 0.182 0.187 0.200 0.219 Module 3: Portfolio Theory, Diversification, Efficient Frontier  The frontier traces out possible portfolios that we can created using risky assets. The upper portion of the frontier is known as the “efficient frontier” The investment frontier shown here plots the standard deviations and expected returns for the portfolios described in the table on the prior slide. Investment Opportunity Set 0.210 1 Expected Returns 0.200 0.190 7 0.180 6 8 9 10 0.170 5 4 3 0 2  Leftward movement in this space corresponds with a decrease in risk.  The portfolios along the efficient frontier dominate portfolios along the bottom portion of the frontier. 11 12  As investors our “choice variables” are the 0.160 0.150 0.100 0.150 0.200 0.250 0.300 Standard deviation 0.350 0.400 0.450 investment weights. I.e., the E[r] and of each of the underlying assets are given, but we can then make investment weight choices to combine these assets into portfolios with targeted return and risk characteristics. Module 3: Portfolio Theory, Diversification, Efficient Frontier  Whether we are using only 2 underlying risky assets or many underlying risky assets the same type of frontier can be traced out. The investment frontier shown here plots the standard deviations and expected returns for the portfolios that could be created by combining the various risky assets together.  Without a risk-free asset the most efficient portfolios (best risk-return characteristics) appear along the efficient frontier.  The portfolios along the efficient frontier dominate portfolios and individual assets that appear in the interior. Module 3: Portfolio Theory, Diversification, Efficient Frontier  If investors can invest in both risky and risk-free assets then new portfolios can be created along the CAL tangent to the frontier.  The CAL tangent to the frontier has the highest Sharpe ratio of all possible CALs.  The CAL shown here traces out possible portfolios that can be created with 2 underlying assets: the tangency portfolio and the risk-free asset.  The tangency portfolio itself is a combination of risky assets. Module 3: Portfolio Theory, Diversification, Efficient Frontier  Less correlated assets tend to shift the frontier left. This increases the Sharpe ratio of the CAL tangent to the frontier.  Correlation is bounded between (Q20) (Q21) (Q22) negative 1 and positive 1. Most assets have small positive correlations.  There are benefits to diversification even for assets with 0 correlation.  Some assets are interesting to consider adding to a portfolio not because they have great risk-return characteristics as a stand-alone investment but because they have interest correlation characteristics with the rest of your portfolio. Module 3: Portfolio Theory, Diversification, Efficient Frontier  Introducing new asset classes moves the frontier left (more diversification) and allows for the creation of portfolios with better risk-return profiles. Risk Return 14% 12% 10% Expected Return Ex 5: US, F, B Ex 6: US, F, B, R Ex 7: US, F, B, C Ex 8: US, F, B, R, C STP 8% 6% 4% 2% 0% 0% 5% 10% 15% -2% Risk: Standard Deviation 20% This figure is from a popular investments case where the rightmost frontier is attainable using only US and foreign equity and corporate bonds (Ex 5). The left-most frontier is attainable by adding REITs and Commodities in addition to the other 3 asset classes (Ex 8). The 2 CALs show how better riskreturn profiles are possible when the frontier is shifted leftward. Module 4: Risk-return Models, Betas  In finance calculations you need a “discount rate”, “expected return”, “benchmark return”, etc. One way to estimate this return is to use a risk-return equation. The CAPM is one of the most famous risk-return models. The CAPM models the asset’s expected return (left-hand side) as a function of the asset’s systematic risk (beta) multiplied by the market risk premium (Rm = rm – rf). The CAPM can be written as a regression equation: Once we have a formal equation we can solve for the “expected value” and for the “variance”. The regression line is the one that minimizes the sum of squared residuals. The slope of the line is the beta. Module 4: Risk-return Models, Betas  The CAPM intuition comes from a set of assumptions. The implications from these assumptions directly explain the form of the CAPM equation. A simplified list of the assumptions: 1. We are all “price takers”. 2. We are all rational mean-variance optimizers. 3. We all have the same set of assets to choose from when making a portfolio and we utilize the same information and approaches to forming our expectations about future returns as well as risk. Implications:  We will all seek the risky portfolio on the efficient frontier with the highest Sharpe ratio.  We will end up investing in a combination of the tangency portfolio and the risk-free asset.  We all will be diversified.  Everyone will assume that E[rm] – rf is a fair return for 1 unit of market risk. Module 4: Risk-return Models, Betas  The assumption of rational mean-variance optimization implies that everyone will seek diversified portfolios. Hence, firm-specific risk is not rewarded in the risk-return formulas. Model: E[ri] = rf + βi(E[rM]-rf) Intuition: In words, the CAPM predicts that the expected return on an asset is the risk-free rate of return plus a risk premium equal to rm – rf times the amount of systematic risk in the asset. Note that beta is a measure of systematic (not firm-specific) risk. Under the CAPM the systematic risk is measured by beta which is a standardized measure of the covariance between how asset i’s returns move with market returns. βi = Cov(ri, rm )/ Var(rm) Module 4: Risk-return Models, Betas  The CAPM is often used to estimate what a “fair return” or an “expected return” would be for a given level of risk as measured by beta. The security market line (SML) is a picture of the CAPM model. The height of the line for a given beta value is the CAPM expected return for that amount of risk. If an asset has no systematic risk (beta = 0) the CAPM implies that the risk free rate would be a fair rate of return. 36 Module 4: Risk-return Models, Betas  The CAPM has some limitations and requires some assumptions to use. • The model requires some unrealistic assumptions. For example, not everyone uses a rational mean-variance approach, not everyone has the same taxes, access to information, etc. • The model has limited ability to explain real-world returns. • If you are using the CAPM to predict returns you need to input a number for the market risk premium. Different people have different opinions about what it should be.  The DCF valuation approaches we talked about in later modules use the CAPM to solve for the cost of equity. 37 Module 4: Risk-return Models, Betas  Multifactor models like the Fama-French 3-factor model share some of the same intuition as the CAPM but assume you need multiple betas to adequately measure market risk. • All of the risk-return models we talked about in FIN 355 assume that only market risk (not firm-specific) risk is compensated because rational investors would not bear risk they don’t need to. This means that investors would seek diversified positions. • All of the risk-return models we talked about use one or more betas to measure that risk. • In the FF 3-factor model there are firm-size-related and market-to-book-related factors in addition to the CAPM market-factor. 38 FIN 355 Course Outline Module 1 2 3 4 5 6 7 Lecture Topics Assignments Introduction to Debt and Equity Markets HW 1, 2 Risk and Return, Correlation, Standard Deviation, CAL (Midterm 1) HW 3, 4 Portfolio Theory, Diversification, Efficient Frontier HW 5 Risk-return Models, Betas (Midterm 2) HW 6 Security Analysis and Valuation HW 7, 8 Derivative Markets HW 9 Business Cycles, Inflation, Efficient Markets, Investing Approaches (Final Exam) HW 10, 11 Module 5: Security Analysis and Valuation  The price of a bond, the price of a share of stock, and the overall value of a firm can each be estimated using discounted cash flow (DCF) valuation techniques. General approach to DCF valuations: 1. Forecast the cash flows tied to the financial asset. • Bond cash flows involve coupons and face value • Equity cash flows include dividends and future resale value • Firm cash flows are measured using FCFs 2. Choose an appropriate discount rate for those cash flows. • Debt cash flows are discounted using the rD • Equity cash flows are discounted using the rE • FCFs are discounted using the WACC 3. Use time value of money formulas to discount the cash flows to year 0 dollars. The price is the present value of all future cash flows. • Formulas that move single cash flows • Formulas that calculate the PV of an infinite series of either flat or growing cash flows 40 Module 5: Security Analysis and Valuation  The price of a bond and the price of a share of stock can be estimated using discounted cash flow techniques. These require TVM formulas and a discount rate. The bond price can be thought of as the present value of future coupons and face value. The discount rate would be the “cost of debt” (rD). The value of a share of stock can be thought of as the present value of expected future dividend payments and resale value. The discount rate would be the “cost of equity” (rE). 41 Module 5: Security Analysis and Valuation  Bonds are debt claims. They tend to have priority over equity claims and tend to have prespecified time horizons. Miscellaneous comments related to bonds: • rf < r D < rE • Credit ratings provide information about the probability of default. Ratings can be investment grade or speculative/junk/high yield. • Most corporate bonds have fixed coupon rates and are issued at par. Over the life of the bond, the rates in the wider economy will fluctuate even though the coupon rate doesn’t. This is why the yield to maturity on a bond is a better estimate of the cost of debt than the coupon rate. • • • • You can create a synthetic credit rating based on financial ratios. Zero coupon bonds are discount bonds. Bond prices converge on the face value as the maturity date approaches. Bond prices move opposite interest rate changes. Bonds with longer lives and lower coupon rates tend to have more interest rate risk. 42 Module 5: Security Analysis and Valuation  Stocks are equity claims. Stockholders are residual claimants and owners of the firm. Miscellaneous comments related to stock: • rf < r D < rE • As residual claimants, stockholders benefit (and suffer) from the consequences of all decisions at the firm. • Equity claims typically don’t have a prespecified time horizon. This is why we model the equity cash flows as infinite series. The perpetuity and constant growth formulas allow you to easily calculate the PV of an infinite series. • The CAPM is often used to calculate the cost of equity. 43 Module 5: Security Analysis and Valuation  If you assume that the infinite series of future cash flows won’t grow then you can use a perpetuity formula to calculate the present value of the series. With the no growth assumption for dividend discount model (r = cost of equity): …  share-level cash flows Price0 Price0  this is the TVM formula for the PV of a perpetuity With the no growth assumption for FCF discount model (r = WACC): … Enterprise Value0  firm-level cash flows Enterprise Value0 44 Module 5: Security Analysis and Valuation  If you assume that the infinite series of future cash flows will grow at a fixed growth rate forever then you can use a constant growth formula to calculate the PV of the series. With a constant growth assumption for dividend discount model (r = cost of equity): and Price0  This is the PV of a constant growth model. Also known as a Gordon growth or growing perpetuity model. Price0 With a constant growth assumption for FCF discount model (r = WACC): and Enterprise Value0 Enterprise Value0 45 If the firm is profitable and expected to continue doing business in the future then the forecasted cash flows extend indefinitely into the future. What are 3 forecasting approaches used to calculate the PV of an infinite series of cash flows? 1. Constant cash flow (no growth case, perpetuity formula) PV0 , 2. Firm Value0 Constant growth (constant growth case, growing perpetuity formula) PV0 , 3. Share Price0 , Share Price0 , Firm Value0 Two stage (high or irregular growth followed by constant growth) Important Intuition: The same 3 modeling approaches can be used with an infinite stream of dividends or an infinite stream of FCFs Module 5: Security Analysis and Valuation  The present value of FCFs is the enterprise value. This can be used to estimate the share price. • Enterprise Value = PV of FCFs • Enterprise Value = Market Value of Debt + Market Value of Equity - Cash • Enterprise Value = D + E – Cash Assuming the company has 1 class of shares the share price can be estimated as E divided by the number of shares outstanding. 47 Module 5: Security Analysis and Valuation  Knowing the assumptions that are involved in DCF valuations it is not surprising to see different analysts have different price targets Reasonable people could have different opinions about…. • What will the future cash flows be? (easier with bonds, harder with equity and firms) • What are the appropriate discount rates? • If you are using the CAPM, which risk-free rate and what market risk premium are you going to use. • What will with future growth be in the cash flows? • Which infinite series-related model will you use?  DCF valuations require a lot of assumptions. 48 Module 5: Security Analysis and Valuation  You can also estimate the value of a share and/or firm using ratios from a public peer firm. Comments on relative valuation, comparables, multiples, etc.: • This approach only makes sense if you believe the market should value the cash flow streams at 2 firms in the same way. • You can do a relative valuation using different ratios.  Relative valuations sweep all the various specific DCF-related assumptions about growth, risk, cash flows, etc. into 1 all-encompassing assumption that the market should value the cash flow streams at 2 companies in a similar way. 49 Module 6: Introduction to derivative markets and funds  Investors can trade financial contracts that derive their values (and payoffs) from what happens over time to the price of an underlying asset. Comments about the option and futures markets: • 2 assets – the derivative contract and the underlying asset • Option contracts provide the option but not the obligation to buy or sell the underlying asset at the strike price. Options are allowed to expire if they are out-of-the-money. • Futures contracts need to be exited by taking the opposing position before expiration. • Futures and options allow for greater leverage in some investments. • Futures and options can be used to hedge and/or speculate on future price movements in the underlying asset. • There are pricing models for options and futures. • Futures contracts can be used to create financial exposure to a number commodities, currencies as well on contracts based on the VIX. 50 Examples of some of major categories of futures contracts (Table 22.1) Module 6: Introduction to derivative markets and funds  Funds provide a relatively easy way to invest in a diversified portfolio. Some funds are more tax efficient and/or have smaller fees. Comments about the funds: • There are thousands of mutual funds and ETFs available to investors. • Many people have the opportunity to invest in funds via their employer-sponsored retirement plans. • Mutual funds • Describe their investing approach in detail in the prospectus. • Can have a variety of front-end, annual, and/or back-end fees. • Can trigger tax events for investors due to the pass-through status • ETFs • Have grown a lot in recent years • Tend to have lower fees than mutual funds • Can be traded during market hours 52 Module 6: Introduction to derivative markets and funds  Hedge funds are only available to a subset of investors, tend to have aggressive fee structures, and often use different investment strategies over time. Mutual Funds Hedge Funds Investment methods Buy publicly traded securities. Little use of leverage or short-sales. Bound by prospectus. Also can buy non-public securities, currencies and commodities. Wide use of leverage and shortsales. Investors No specific limit. Small number of sophisticated investors Diversification Hold broad mix of assets. Holdings are often concentrated. Fees Relatively low fees (compared to hedge funds, not ETFs) that do not depend on performance Relatively high fees that depend on performance. “2 and 20” Withdrawals/liquidity Investors can sell back shares at any time (end of trading day) Investor money is “locked up” for long periods Regulation Heavy Regulation Light Regulation Initial investments Relatively low Very high investments necessary. 53 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  The economy has experienced repeated multi-year cycles of upswings and downswings across the last century. 54 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  The cyclical up and downswings in the stock indices show that aggregate expectations for future firm cash flows are affected by cycle-related news. This graph shows the S&P 500 over 30 years. Firmvalue=¿ Firmvalue=¿ Value can be modeled using discounted cash flow approaches. The S&P500 can be viewed as an aggregation of 500 firms’ DCFs. Note the aggregate revision in expected cash flows that must occur for a market-wide decrease in the stock index. 55 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  Different types of investments are more or less sensitive to certain parts of the cycle. There are investment strategies that try use this intuition to improve returns. Beta is calculated using the covariance of an asset’s returns with the market. This means that high beta stocks not only tend to move in the same direction as the market but they also tend to move more in that direction than the market. Implications: • High beta stocks, on average, are likely to appreciate a lot during expansions. • High beta stocks, on average, are likely to lose a lot of value during contractions. 56 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  Different types of investments are more or less sensitive to certain parts of the cycle. There are investment strategies that try use this intuition to improve returns. Bankruptcies tend to cluster during downturns and recessions. Implications: • Investing in speculative or high risk debt is especially risky during downturns. • Investing in equity at firms that have speculative bond ratings (or financial ratios that would be consistent with financial distress) is especially risky during downturns. If the firm defaults on their debt the equity holders may get nothing. 57 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  Different types of investments are more or less sensitive to certain parts of the cycle. There are investment strategies that try use this intuition to improve returns. Certain industries and types of firms tend to do well during different parts of the cycle. Implications: • Larger and more stable firms tend to be less sensitive to downturns. • Industries and/or firms that sell discretionary items tend to experience changes in cash flows that mirror the business cycle. • Industries and/or firms that sell consumer staples tend to have more stable cash flows. • Sector rotation approaches may help you know how to tilt your portfolio over time. 58 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  There are economic indicators that can help investors form opinions about where we are in the business cycle. The leading indicators tend to move prior/early during cycle changes. Coincident indicators tend to move later but during cycle changes. The Conference Board is one example of an organization that aggregates the various indicators into indices. 59 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  Historically inverted yield curves have occurred prior to recessions in the US. The plot on the left shows the 10year treasury rate minus the 1-year treasury rate. An inverted yield curve appears when the shaded region dips below 0. The plot shown below is an example of an inverted yield curve. 60 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  Inflation is generally talked about as the rate at which prices as a whole are increasing. Positive inflation represents a reduction in purchasing power. Recessions are shown by vertical shaded regions. Nominal rates include the effect of inflation. This means that “interest rates” were high in the years that inflation was high. The Fed also “raises rates” at times to try to reduce inflation. 61 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  If inflation is higher than the return on your investments you are effectively worse off over time. Some investment types are more/less sensitive to inflation. • Savings accounts (Returns are often lower than inflation) • Equity (Different stocks are affected differently. Some people argue that value stocks do well) • Bond investments (Bond prices fall as rates go up) • TIPs • REITs (Different REITs are affected differently. Some have monthly leases that naturally go up with inflation) • Commodities (Commodity prices tend to move with inflation. If you are investing via futures then the roll yield needs to be considered.) 62 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  Prices are driven by millions of people trading based on their individual information and intuition. This means that prices are “information rich”. R e t u r n s 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 In class we talked about examples of stock prices reacting to announcements of: Terremar k Savvis • • • • 1- 7- 13 17 23 30 5- 11 18 24 28 3- 9- 15 22 28 De De -D -D -D -D Ja -J -J -J -J Fe Fe -F -F -F c- c- ec ec ec ec n-1 an an an an b- b- eb eb eb 10 10 -1 -1 -1 -1 1 -1 -1 -1 -1 11 11 -1 -1 -1 1 1 1 1 1 1 1 0 0 0 0 63 Mergers (direct and indirect) Earnings Management Fraud How fast does information get into the price? If the information is already reflected in the price does that mean you can’t trade on it? Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  If prices already incorporate all this information, what information is left that can be used to predict future returns? Efficient market hypothesis (EMH): Security prices are “efficient” in that they already reflect information. “An informationally efficient market is one in which information is rapidly disseminated and reflected in prices.” If prices are efficient, then it is difficult to predict future price changes (i.e., future returns) using current information because the current information is already, to some extent, reflected in the current price.  Different people have different opinions about the efficiency of the market. Prices clearly react quickly to announcements showing that (1) private information is not fully incorporated in the price prior to the announcement, and (2) once the information is released the pricing of the new information appears to occur rapidly.  Some active traders would argue that the full implications of the new information may not be immediately or correctly understood. Others would argue that human behavior (e.g., herding, overreaction, benchmarking, behavioral finance) also can, at least temporarily, affect prices in semi-predictable ways. 64 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  If prices already incorporate all this information, what information is left that can be used to predict future returns? • If all public information is quickly and correctly priced then technical analysis, fundamental analysis, and relative valuation using previously released public information won’t help identify undervalued assets. Only the most recent information would be helpful in the analysis.  Note that the idea of a risk-return relationship is not invalidated by market efficiency arguments. Even if prices are mostly efficient, there would be value in creating diversified portfolios with targeted characteristics that would still be expected to provide a fair return over time for the amount of risk in the portfolio. 65 Module 7: Business Cycles, Inflation, Efficient Markets, Investing Approaches  If prices already incorporate all this information, what information is left that can be used to predict future returns? • If, however, only some of the public information is quickly priced, or if the information takes days or weeks to fully be understood and priced, or if the implications of the information are unclear and can be misunderstood by many/most market participants, then there is still room for investors to try to identify undervalued assets based on their intuition, experience, and information.  Note that active traders must believe the market prices are sometimes too low and/or too high and hence don’t fully or correctly incorporate all public information otherwise there would be no reason to spend time trying to find individual investments using publicly available information.  Using relative valuation to try to find an undervalued or overvalued asset requires the belief that the market pricing will eventually incorporate all the information in a correct way but that it can take time to do so. Otherwise there would be no reason to compare the relative valuation of 2 assets and to expect a convergence in the valuation metric. 66 Lecture Preview Big-Picture Motivation: FIN 355 is a beginning investments class designed to introduce the equity and debt markets, how stocks are traded, common approaches for estimating stock value, basic bond calculations, and to provide some intuition and experience with the mathematical measures and concepts related to portfolio risk and return calculations as well as provide a brief introduction to options and futures. This final lecture will review some of the key ideas from these earlier lectures and then end by discussing how these ideas relate to some common investing approaches. Discussion Outline: • What are the key pieces of intuition, terminology, and ideas covered in the 7 modules of FIN 355? • How do these ideas relate to common investing approaches? Using concepts and intuition introduced in FIN 355, what are the upsides and risks associated with these approaches? What are the underlying assumptions that must exist for these approaches to work? Investing approaches: Invest in 1 (or just a few firms) Sometimes you hear people talk about investing all, or a significant portion, of their wealth in 1 or just a few firms. They sometimes justify this approach by arguing that they believe in the firm’s products and think the firm is going to grow. This approach involves significant risk. Potential Upside Potential Downside/Risk • If the firm’s current price doesn’t already reflect the future good performance then your investment could appreciate as investors learn more positive information about the firm over time. • Potential for large annual returns. • This is a non-diversified portfolio. You will experience both market and firm-specific risk. • Undiversified portfolios tend to experience more volatility than diversified portfolios and you can more easily lose everything if something unexpected occurs. Assumption(s) needed for this approach to make sense: The firm you are investing in must currently be undervalued compared to its true value which would require you to believe that your optimistic view about the firm’s future is correct even though this view is different than that of the majority of investors. If the majority of investors shared your same optimism about the firm’s future then the current price would have already risen. 68 Investing approaches: Invest in S&P500 firms via a fund that tracks the index Sometimes you hear people talk about investing in the S&P500 or some other broad index. They sometimes support this approach by arguing that it has a good historical track record and provides a relatively easy way to gain the benefits of diversification. This is a reasonable basic approach. Potential Upside • History suggests around 10 - 12% average annual returns over long horizons. • Diversification means you are unlikely to lose large portions of your wealth in a single year. Potential Downside/Risk • Some years the entire market is down and you could lose 30+%. • Unlikely to see annual returns above 10-20%. • Bonds and other asset classes do well during certain periods when stocks to not. Holding a diversified portfolio may mean you need to invest in more than just domestic equity. Assumption(s) needed for this approach to make sense: The S&P500 firms will experience similar stock performance in future years as they have in the last 50 years. The S&P500 firms will not decrease in value over your investment horizon. 69 Annual S&P500 returns over the last 30 years Figure from www.macrotrends.net 70 10-Year Annualized Rolling Returns on S&P500 Index Most 10-year periods had positive returns. 71 Investing approaches: Invest in bonds (normally as a part of an overall portfolio) Sometimes you hear people talk about investing in bonds especially as they approach retirement. They sometimes justify this approach by arguing that the volatility in bond returns is lower than in stocks and hence tilting the portfolio more towards bonds helps reduce the possibility of large losses just before retirement. Potential Upside Potential Downside/Risk • Investment grade and government bonds are less volatile than most equity investments. If there were a sudden economic downturn they would likely lose less value. • Bond returns are often better than savings account returns. • Bond prices move opposite interest rates. If interest rates go up then bond prices will go down. • The returns on investment grade bonds tends to be lower than the return on equity in most years. Assumption(s) needed for this approach to make sense: You would not want to buy bonds at high prices and then sell them at low prices if interest rates surged during the holding period. Bonds are sometimes more attractive than equity if you are trying to eliminate the possibility of large losses, you think that equities are overpriced, and/or the stock market is likely to decrease in value. Note that the idea of equities being “overpriced” and “stock market corrections” rely on the idea that assets can be mispriced. 72 Investing approaches: Invest in low PE stocks that may also satisfy other criteria. Other variations of “value” investing include low price-to-cash or other methods of identifying firms that are trading below their intrinsic value. “Stocks bought at low price/earnings ratios afford higher earnings yields than stocks bought at higher ratios of price-to-earnings. The earnings yield is the yield which shareholders would receive if all the earnings were paid out as a dividend.” Some people argue that value stocks tend to better over time than non-value stocks. -- quote from “What Has Worked In Investing” Potential Upside Potential Downside/Risk • There are papers that show low PE groups of firms performed well in many years in the 1970s-1990s. Value-investing strategies have done well at different times over the last 50+ years. If the past is like the future, then this approach could lead to good returns going forward. • Low PE and other value-investing approaches have not done well in every year over time. This approach does not always beat a simple diversified approach. • Some firms have low PE ratios for good reasons. • It can be difficult to achieve good diversification using this approach if all investments need to have the same value metric. Assumption(s) needed for this approach to make sense: Whatever method that is used to identify the undervalued asset (e.g., low PE ratio, low market to book ratios, etc) is based on fundamental analysis. This kind of investor must believe that assets can be temporarily undervalued but that they eventually will be fairly priced. 73 Investing approaches: Invest in small or mid-cap stocks Portfolios of small and/or mid cap stocks have outperformed portfolios of large stocks in many years. Large stocks tend to be less volatile and less risky. Potential Upside Potential Downside/Risk • Higher returns than from the S&P500 • Higher likelihood of experiencing a large loss in a single year – especially during downturns. • Small and mid-cap stocks tend to lose more value during downturns than large stocks. • Liquidity issues Assumption(s) needed for this approach to make sense: Small and mid-cap stocks have historically tended to do well during expansions. If you invest in small or mid-cap stocks you would need to believe they would do well over the coming years. This requires you to believe the current low price does not already reflect the growth in the coming years. 74 My personal approach to investing (I am not providing any specific investing advice) I invest in a mix of US equities, international equities, and US corporate bonds. Most of these investments are purchased via ETFs with low fees. I invest both through employer-sponsored retirement plans (which also include mutual funds) as well as via a discount online brokerage account. If I invest in a mutual fund, I look carefully at the fee structure and investment strategy. I increase the proportion of small and mid-cap equities in my portfolio during years when I think the economy will expand and I increase the proportion invested in large caps at other times. I avoid long-term bonds in years that I expect interest rates to rise. I try to avoid making a lot of trades and/or changes to my portfolio so the changes I do make occur infrequently based on my opinion of where we are in the business cycle which is based on leading economic indicators. My approach towards investing doesn’t really allow for explosive growth in any one year due to diversification but it also takes advantage of the reduction in risk associated with diversification. 75 I hope you have enjoyed learning about investments in FIN 355 this semester. As an introductory course, we didn’t have enough time to go into more depth on some of the topics but I hope you now have a better sense of some of the popular financial markets, the types of equity and debt securities that people invest in, how retail investors can trade stocks, and new intuition for how diversification affects portfolio performance. This class was designed to introduce these markets and securities as well as give you an introduction to the terms, ideas, and formulas that are used in this area. All investments have risk. If you choose to invest in stocks, bonds, futures, and/or options you will be choosing to accept a certain amount of risk. There are no guarantees. But hopefully the topics and information we have covered will help you better understand your choices and help you make more informed decisions going forward. I hope the topics we have covered in FIN 355 will be useful to you in your life. Good luck with everything! Best regards, Dr. Schonlau 76 Thank You