Class 1
A random walk is one in which future steps or directions cannot be predicted on the basis of
past actions. When the term is applied to the stock market, it means that short-run changes
in stock prices cannot be predicted. A speculator buys stocks hoping for a short-term gain
over the next days or weeks. An investor buys stocks likely to produce a dependable future
stream of cash returns and capital gains when measured over years or decades.
Investing is a method of purchasing assets to gain profit in the form of reasonably
predictable income (dividends, interest, or rentals) and/or appreciation over the long
term. It is the definition of the time period for the investment return and the predictability of
the returns that often distinguish an investment from a speculation. Investing methods differ
depending on the capacity for risk, which is correlated to life cycle (at which stage of your
like you’re in, whether you can afford it) and attitude towards risk.
All investment returns—whether from common stocks or exceptional diamonds—are
dependent, to varying degrees, on future events. That's what makes the fascination of
investing: It's a gamble whose success depends on an ability to predict the future.
Traditionally, the pros in the investment community have used one of two approaches
to asset valuation: the firm-foundation theory or the castle-in-the-air theory.
The firm-foundation theory argues that each investment instrument, be it a common stock
or a piece of real estate, has a firm anchor of something called intrinsic value, which can be
determined by careful analysis of present conditions and future prospects. When market
prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling)
opportunity arises, because this fluctuation will eventually be corrected—or so the theory
goes. Investing then becomes a dull but straightforward matter of comparing something's
actual price with its firm foundation of value.
The firm-foundation theory includes the concept of discounting. Discounting involves
looking at income backwards. Rather than seeing how much money you will have next year
(say $1.05 if you put $1 in a savings bank at 5 percent interest), you look at money expected
in the future and see how much less it is currently worth (thus, next year's $1 is worth today
only about 95 cents, which could be invested at 5 percent to produce approximately $1 at
that time). Williams went on to argue that the intrinsic value of a stock was equal to the
present (or discounted) value of all its future dividends. Investors Page 30 were advised to
"discount" the value of moneys received later.
The logic of the firm-foundation theory is quite respectable and can be illustrated best with
common stocks. The theory stresses that a stock's value ought to be based on the stream of
earnings a firm will be able to distribute in the future in the form of dividends. It stands to
reason that the greater the present dividends and their rate of increase, the greater the value
of the stock; thus, differences in growth rates are a major factor in stock valuation. Now the
slippery little factor of future expectations sneaks in. Security analysts must estimate not only
long-term growth rates but also how long an extraordinary growth can be maintained. When
the market gets overly enthusiastic about how far in the future growth can continue, it is
popularly held on Wall Street that stocks are discounting not only the future but perhaps
even the hereafter. The point is that the firm-foundation theory relies on some tricky
forecasts of the extent and duration of future growth. The foundation of intrinsic value may
thus be less dependable than is claimed.
,The castle-in-the-air theory of investing concentrates on psychic values. John Maynard
Keynes, a famous economist and successful investor, enunciated the theory most lucidly in
1936. It was his opinion that professional investors prefer to devote their energies not to
estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to
behave in the future and how during periods of optimism they tend to build their hopes into
castles in the air. The successful investor tries to beat the gun by estimating what investment
situations are most susceptible to public castle-building and then buying before the crowd.
According to Keynes, the firm-foundation theory involves too much work and is of doubtful
value.
With regard to stocks, Keynes noted that no one knows for sure what will influence future
earnings prospects and dividend payments. As a result, Keynes said, most persons are
"largely concerned, not with making superior long- term forecasts of the probable yield of an
investment over its whole life, but with foreseeing changes in the conventional basis of
valuation a short time ahead of the general public." Keynes, in other words, applied
psychological principles rather than financial evaluation to the study of the stock
market. He wrote, "It is not sensible to pay 25 for an investment of which you believe the
prospective yield to justify a value of 30, if you also believe that the market will value it at 20
three months hence."
In this kind of world, there is a sucker born every minute—and he exists to buy your
investments at a higher price than you paid for them. Any price will do as long as others may
be willing to pay more. There is no reason, only mass psychology. All the smart investor has
to do isto beat the gun—get in at the very beginning. Thistheory might less charitably be
called the "greater fool" theory. It's perfectly all right to pay three times what something is
worth as long as later on you can find some innocent to pay five times what it's worth.
Businesses/governments need finance to operate the company/state. An investor looks for
profitable investment opportunities. Investors provide capital to businesses/governents in the
form of shares, bonds and loans. That is done through financial markets. Investors are
willing to provide money in order to receive returns (dividends for stocks, coupons for bonds,
interest for loans).
Assignment: investment report 40% of the grade. Groups of two. Choose a stocklisted
company for analysis. Send Resing an email with group details and the company selected.
Deadline: Thursday, October 21st midnight. Written exam at the end of the course: 60%.
Market capitalization is the share price multiplied by the number of shares traded (over a
certain period of time).
Indexes:
- S&P 500 is comprised of 500 biggest American companies by market capitalization;
- NASDAQ (National Association of Securities Dealers Automated Quotations) is
comprised of more than 3000 tech companies (market capitalization defines weight);
- Dow Jones is comprised of 30 companies selected on share price;
- AEX (Amsterdam Exchange) is comprised of 25 biggest stock listed companies in the
Netherlands by market capitalization.
Capital gains translate to nominal returns. A nominal return is a return gained before
accounting for inflation. A real return is the increase of purchasing power, after
accounting for inflation.
,Fisher equation for calculating real return:
N = Nominal return;
i = Inflation rate;
R = Real return.
Example:
A stock is bought for $ 20. During the year a dividend is received of $ 0.40.
Exactly one year after you bought the stock, the stock quotes $ 22.
What is the holding period return? Dividend yield: $0.40/$20 = 0.02 (2%), Capital gain:
$2/$20 = 0.1 (10%), hence total yield is 12%. These are nominal returns.
Let’s further assume that the price index of consumption increased from 103 to 108 during
the year; what is then the annualized real return?
Inflation: 108 – = 0.0485 (4.85%)
1..0485 – 1 = 0.0682
Real return is 6.82%.
Capital gains yield (CGY) is the price appreciation on an investment or a security
expressed as a percentage.
CGY = (Current Price – Original Price) / Original Price
Dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows
how much a company pays out in dividends each year relative to its stock price.
Buying on margin is using loans to buy stocks. It is also called leverage. That can be very
profitable, however, can also be risky in case stock prices fall.
, Example:
Assume you buy 2000 shares at a price of $ 20 per share;
Half of the investment is financed by own capital, the other half by a loan;
Interest rate against which can be borrowed is 6%;
Assume that after one year the stocks can be sold for $ 22 and that during the holding
period, a $ 0.40 per share dividend has been received;
Calculate the return on equity for the holding period?
Total investment is 2000 x $20 = $ 40,000 ($ 20,000 equity and $ 20,000 loan)
Interest on loan is: 6% x $20,000 = $ 1,200
Total return = $4,000 (capital gain) + $800 (dividends) - $1,200 (interest) = $3,600
Return on equity: $3,600/$20,000 = 0.18 (18%)
If the share price drops from $ 20 to $ 18, the total return will be
$800 (dividends) - $1,200 (interest) - $4,000 (capital loss) = minus $4,400
Return on equity: - $4,400/$20,000 = - 0.22 or - 22%
In case of falling prices, the broker runs the risk that the investor is unable to meet his/her
obligations. For this reason brokers require that one’s equity position doesn’t fall below a
certain % of the value of the stocks bought; this is what we call a margin requirement. If the
equity falls below this figure, the investor receives a margin call from the broker, implying
he/she will have to deposit additional money in account with the broker; If you don’t meet this
call, the broker has the right to liquidate the stock position.
Example:
Assume that the margin requirement is 40% (meaning the value of one’s equity position is
not supposed to drop below 40% of the value of the shares).
At what price can you expect a margin call?
2000P - $ 20,000 = 40% x 2000P
2000P - $20,000 = 800P
1200P - $ 20,000 = 0
1200P = $ 20,000
P = $ 16.67
Homework:
