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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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LECTURE 1 2 3
Since the word investment is used in different contexts and in each context it has a different meaning
therefore it is deemed important that right from the beginning it is clarified as to what is meant by
investment in this course. This course is about investment in securities market. It is not a course about
investment in corporate assets such as NWC and FA; as typically these decisions are called investing
decisions in corporate finance. This course is not about investment in an a countrys or provinces
infrastructure such as roads, bridges, schools, hospitals, etc; as this is the meaning attached to the word
investment by economists. This course is not about foreign direct investments as depicted by foreign
entities building factories in this country. The course may have some relevance for foreign portfolio
investment by foreigners who may be contemplating investing in securities markets in Pakistan. Both
individual Investors as well as professional money managers in Pakistan working for institutional investors
such as mutual funds, commercial banks, insurance companies, investment banks, pension funds, etc, are
expected to benefit most from this course.
THREE QUESTIONS FACED BY INVESTORS
Any person or institution contemplating investments in securities markets must face three questions:
1. What to buy?
2. What combination to buy?
3. When to buy?
Let us treat these questions in some detail in this lecturer; the rest of the course is also about the further
details, derivations, and analytical skills needed to answer these 3 questions.
Question One: What to Buy (or Sell):
Common sense answer to the question what to buy or what to sell is: buy those (or sell those) securities
that would make you wealthier. But more correctly the answer depends on your position in the market. If
you want to take long position in a security then answer is : buy those securities that would give positive
rate of return (ROR), and thus would increase your wealth. In other word buy those shares whose price is
likely to increase. But if you want to take short position then answer is short sell those securities that are
expected to give negative rate of return; that is , if (ending price beginning price) / beginning price gives
negative answer. Or in other words whose price is likely to fall, doing so would increase your wealth.
Wealth after one year = Wealth now (1 + ROR). This can be written as:
W
1
= Wo (1 + ROR). Note: ROR is written in fraction, say 10% is written as 0.1
Selling is the flip side of buying; you are in the market as investor as long as you have bought some shares
or other securities and have not sold them as yet. It is called having a long position in that security. On
other hand if the shares you had bought earlier have now been sold then you have closed your long
position, or simply you are out of the market. Also if you initiated your entry in the market by selling
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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some shares which you did not have but you had borrowed the shares from a broker to sell them, then it is
called short selling , or simply you have short position in the market. You have an open short position as
long as you do not close your short position by buying the same shares and returning them to the lending
broker. It is necessary that short position is ultimately closed, called short covering, because the share
you initially sold were not owned by you, in fact you had borrowed those shares from the broker and sold
them in the market in the hope of making profit by buying these shares when share price would go down in
future. So in short selling you borrow shares and sell them first and buy later; and you have an open
short position in the market until you buy the shares and return them to the broker from whom you had
borrowed them.

Long Position
For example you bought share of a company at Rs 100 and it is expected to give 10% ROR in one year so
your wealth after one year is going to be :
W
1
= 100 (1 + 0.1). Please note 10% ROR was written as 0.1 in decimal points.
W
1
= 110 Rs. In this case 10% positive ROR has increased your wealth from 100 to 110 Rs.

Similarly if its current price is 100 and after one year expected price is 93, then expected ROR =
(ending price beginning price)/ beginning price
= (93 - 100) / 100 = -0.07 or - 7%
As expected ROR from this share is negative 7% and if you took long position in it, then after one year
your wealth would be:
W
1
= 100 ( 1 + -0.07)
W
1
= 93 Rs. Negative ROR would decrease your wealth from 100 to 93 Rs.

Short Position
It is possible to increase your wealth as investor by investing in a share which is expected to give negative
ROR and whose price is expected to fall during the next year. It can be done by short selling such a share.
In short selling you borrow the share and sell it in the market at current high price; and then hope its price
would fall and you would buy it at that low price and give it back to the person from whom you had
borrowed it. So short selling, or taking short position, requires selling FIRST and buying LATER; while
taking long position requires buying FIRST and selling LATER.
Keeping the example data used above, an investor who shorted this share at 100 at its current price now
and bought it after one year at 93, would have ROR (assuming no dividends):
ROR = (Selling price - buying price ) / buying price
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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ROR = (100 - 93) / 93
ROR = 0.075 = 7.5%
Please note that if you had taken long position in this share you would have bought it at its current price
100, and sell it after one year at 93; then expected ROR from this share would have been:
ROR = (selling price - buying price ) / buying price
ROR = (93 - 100) / 100
ROR = -0.07 = -7%
This was example of a share whose expected ROR is negative, but if you take short position in such shares
you can still earn positive ROR of 7.5% . It happens , as shown above, by selling now at 100 now and
buying later at 93. Therefore shares whose expected ROR is negative, should be short sold , that is, short
position should be taken in such shares; and shares whose expected ROR is positive should be held long,
that is, long position should be taken in such shares.
In summary investors can increase their wealth by:
a) taking short position (sell first, buy later) in those shares which are likely to give negative ROR
b) taking long position (buy first, sell later) in those shares which are likely to give positive ROR.
In real life both types of shares, those whose expected ROR is positive and those whose expected ROR is
negative, are used by investors for investment purposes to increase their wealth. It is important to note that
regulators from time to time impose restriction on short selling in a period when prices are falling; they do
so to stabilize the market prices and to neutralize speculative selling which can further aggravate
downward trend of prices.
How To Select Shares that increase your wealth : SECURITY
ANALYSES
To select securities or shares which are expected to increase your wealth two types of security analyses are
done by security analysts, namely fundamental analysis and technical analysis. Security analysis is done
to identify mispriced securities. By mispricing means that either a security is overvalued or undervalued
at its current market price ( P
0
). Saying that a security is currently mispriced also implies that there is a
fair or just or correct price of the securities; and the price of a currently mispriced security would sooner or
later tend to move toward the fair or just price.

In fact EMH (Efficient Market Hypothesis) says that as new information arrives security prices adjust
accordingly very quickly so that due to arrival of good information prices increase and due to arrival of
bad information prices decrease very quickly; and therefore observed market price of any security on any
day is very close to its fair price. This contention of EMH implies that attempt by investors to discover
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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mispriced securities is fruitless because of markets are informationaly efficient and thus current prices
reflecting all the past and present , public and private, information; thus the current price of a share is very
close to its fair price.

But in real life analysts still do security analysis to discover mispriced securities. Security analysts operate
on the belief that buying undervalued securities would give positive ROR as their price is expected to
increase in future ( and if market is informational efficient such increase in price should take place very
soon); and analysts also believe that shorting the overvalued securities would give positive ROR as their
price is expected to fall in future. The expected direction of price movement in future is based on the
comparison of current market price with the fair or just price of that share. Price of undervalued security
would tend to go up in future toward its fair or just vale; and price of overvalued security would tend to
fall toward its fair or just value. In short security analysis is aimed at identifying the mispriced securities,
because if a share is rightly priced there is no incentive for investors to invest in it; and practically trading
in that share should not take place. A share must be mispriced at its current market price to be attractive
for the investors. To be traded a share should be viewed by some investors as underpriced so taking long
position (buying) now would give positive ROR and by some as overpriced so selling it would seem good
idea to them. On the other hand a share should be viewed as overpriced by some investors so taking short
position (selling) now would give positive ROR when it is bought later at a lower price and at the same it
must be viewed as underpriced by some so they would buy it.
Fundamental Analysis Of Securities
The basics of fundamental analysis of securities have been covered by you in previous courses such as
Corporate Finance I & II. This type of analysis uses fundamental financial data from income statement and
balance sheet of a company such as sales, NI , ROE, EPS, DPS, variance of past RORs, beta of stock; as
well as data from macro- economic variables such as variance of ROR of stock market, GDP growth rate,
interest rate and inflation rate in the economy, etc., to identify mispriced securities. The methodology of
discovering mispricing is based on first estimating a fair or just or theoretically correct price for the share
using fundamental data and then comparing it with the prevailing market price of the share. If current
market price is higher than the estimated fair price, then security is said to be overvalued; and if current
market price of that share is less than the estimated theoretically correct price then that share is called
undervalued. The recommendation for investment decision is then made by security analysts as:
1. Buy undervalued share, or, take long position in undervalued share
2. Short sell over valued share, or, take short position in undervalued share.
Theoretically Correct Price or Fair Value of a Share
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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You know that Expected ROR on share is symbolized in different text books as Ks or Kc; and is
composed of two components namely dividend yield and capital gains yield.
Kc = (DPS
1
/P
o
) + (P
1
P
o
)/P
o
.
If a company does not change 5 policies net profit margin (NI/Sales), total asset turnover (Sales / TA),
equity multiplier TA/OE), dividend payout ratio DPS/EPS), and number of share outstanding- and keep
these policies at the same level as they were last year then percentage growth in OE due to increase in
retained earnings is
g = ROE (1 d ) , and this growth rate ultimately translates into same percentage growth rate in EPS, DPS,
and share price. Keeping 5 policies unchanged means managing a company as well (or as badly) as it was
managed last year.
With these policy restrictions, expected share price after one year (P
1
) is estimated as: P
1
= P
o
(1 + g).
Expected cash dividend per share next year (DPS
1
) is estimated as: DPS1 = DPS
0
(1 + g).
Let us pay little more attention to the growth rate formula: g = ROE (1 - d). Please note that in previous
courses you were taught to analyze ROE in different manners, such as :
ROE = ROIC + (ROIC Ki) Debt / Equity ratio.
Whereas ROIC is return on invested capital and it is equal to EBIT (1 - T) / total capital invested , and
total capital invested can be calculated from LHS of balance sheet as NWC + FA , or from RHS of
balance sheet as LTL + OE. In ROE equation Ki refers to after tax percentage cost of debt capital used in
company; and it is equal to Kd (1 - T), whereas Kd refers to before tax percentage cost of debt capital (or
simply interest rate per year on the debt capital), and T refers to corporate income tax rate. Another
method of analyzing ROE was the DuPont formula that breaks ROE into 3 components:
ROE = NI/S * S/ TA * TA/OE
In the growth rate formula: g = ROE (1 - d), the Dividends Payout ratio (d) refers to percentage of
NI that given by a company as cash dividends, and it is equal to total cash dividend / NI, or on a per share
basis, it is equal to DPS/EPS. In certain text book a variant is used that is called retention ratio and
symbolized as b; please note b = (1 - d) ; if a company pays out , say, 20% of its NI as cash dividends
then the rest 100% - 20% = 80% of NI is retained and reinvested in the business, so retention ratio is 80%
or you can write it as:
b= 1 d
b = 1 0.2
b =0.8.
Fair Value Estimation Using Gordon Valuation Model or DDM: It is a model for estimating Fair or
Just or correct or Intrinsic value of shares, you can view it as theoretically correct value of a share. It is
based on the idea that a share is valuable today because investor expect future cash flows from owning this
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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share; and therefore present value of expected future cash flows from a share is its theoretically correct
value or intrinsic value. The Gordon model can be derived from expected ROR formula.
This expected ROR formula is: Kc = (DPS
1
/P
o
) + (P
1
P
o
)/P
o
. It can be rearranged as a pricing formula
known as Gordon Model and DDM (dividend discount model) with constant growth assumption. This
transformation of Kc formula into a share pricing formula is shown below.
Kc = DPS
1
/P
o
+ (P
1
P
o
)/P
o

(P
1
P
o
) /P
o
is percentage growth rate of share price g in one year that is called capital gains yield. As
discussed above, if 5 policies are constant this growth rate in share price is equal to ROE ( 1 - d). For
example a share is bought at 100 and sold after one year at 120, then (P
1
P
o
)/P
o
= (120 - 100) / 100 =
0.2 = 20%.
So expected ROR from investment in a share, Kc, can be written as:
K
c
= ( DPS
1
/P
o
) + g
K
c
g = DPS
1
/P
o

P
o
(K
c
g) =DPS
1

P
o
= DPS
1
/ (K
c
g).
Fair Value now = = DPS
1
/ (K
c
g).

Note P0 now is referring to current fair value not the current market price because this model is
estimating share value as present value of all future dividends.

Note that in previous courses Expected ROR was shown with symbols K
c
or K
s
. According to this
valuation formula current fair value at time zero is estimated by discounting next year dividends (DPS
1
), or
in other wording current theoretically correct value or fair value or just value is estimated by finding PV of
future cash dividends whereas dividends are expected to grow at constant growth rate every year till
infinity. If dividends are not expected to grow then g is zero in above equation and valuation formula
becomes: P
o
= DPS
1
/ K
c

And that is present value of perpetual dividends discounted at Kc as discount rate.
A share , according to this fundamental security analysis, is mispriced if its current market price is
different from its estimated theoretical price from Gordon formula.

It is important to clarify a prevailing confusion as to the expected cash flows from a share because
sometimes it is said that future cash flows expected from a share are of 2 types: expected cash dividends
and expected selling price; but one should understand that expected future selling price itself is based on
discounted value of expected cash dividends in subsequent years. For example someone buying a share
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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now at Po expects DPS1 as well as P1 as two cash flows, but P1 itself is based upon expected DPS2 and
subsequent dividends being discounted, and similarly P2 is based upon DPS3 and subsequent dividends.
Therefore ultimately it is only expected cash dividends in future years which are relevant cash flows and
their discounted value gives value to shares today. To clarify it :
Po = DPS1 / (Kc g)
P1 = DPS2 / (Kc g)
P2 = DPS3 / (Kc - g)
And so on.
The same can be written as:
P
0
= DPS
1
/ (1 + Kc)
1
+ DPS
2
/ (1 + Kc)
2
+ ..+ DPS
n
/(1 + Kc)
n

P
1
= DPS
2
/ (1 + Kc)
1
+ DPS
3
/ (1 + Kc)
2
+ ..+ DPS
n
/(1 + Kc)
n

P
2
= DPS
3
/ (1 + Kc)
1
+ DPS
4
/ (1 + Kc)
2
+ ..+ DPS
n
/(1 + Kc)
n


Exercise of finding fair value
A share is currently priced at 100 rupees and its ROE last year was 24%, its dividend payout ratio was
25%, and it paid 5 rupees cash dividends per share. You expect its dividend payout ratio to remain
unchanged next year and also the other 4 policies are expected to remain unchanged , namely profit
margin, asset turnover, financial leverage, and number of shares outstanding. Please find: growth rate,
expected DPS next year, expected price by next year, expected dividend yield, expected capital gains
yield, expected rate of return, and its fair value.
Its expected growth rate is:
g = ROE (1 - d)
g = 24% (1 - 0.25)
g = 18%
Then you would estimate its
P
1
= Po (1 + g) = 100 (1 + 0.18) = 118 rupees
DPS
1
= DPS
0
(1 + g) = 5(1 + g) = 5.9 rupees
Expected Kc = (P
1
- P
0
)/P
0
+ DPS
1
/ P
0

Expected Kc = (118 - 100) / 100 + 5.9 / 100
Expected Kc = 0.18 + 0.059
Expected Kc = 0.239 or 23.9 %
Now question is whether its current price of 100 rupees is also its fair value?
Fair value = DPS1 / (Kc g)
Fair value = 5.9/ (0.239 - 0.18) = 5.9 / 0.059 = 100 rupees
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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That is same as its current market price as it should be because g values inserted in the valuation formula
were the same as used in calculating the expected rate of return, and the discount rate , Kc, used in
valuation formula was the same as estimated using the g value.

Please remember it that in real life analysts do not agree on the same growth rate and therefore end up
estimating different fair values. Let us assume three analysts agree about expected rate of return 23.9%
but are estimating three different expected growth rates for this company; 10%; 20% ; and 22% ; then each
of them would end up estimating a different fair value for this share as shown below.
Fair value at 10% growth rate:
DPS1 = DPS0 (1 + g)= 5(1 + 0.1) = 5.5
Fair value = DPS1 / (Kc g) =5.5/ (0.239 - 0.10) = 39.5 rupees
Decision: as market value 100 rupees is more than fair value 39.5 rupees therefore this share is overvalued
at its current market price and you should not buy it, or if you have, it should be sold, or if you do not have
it you can short sell it at 100 and buy it later on when its price fells to your expected fair value of 39.5
rupees.
Fair value at 20% growth rate
DPS1 = DPS0(1 + g) = 5(1 + 0.2) = 6
Fair value = DPS1 / (Kc g) =6/ (0.239 - 0.2) = 153.8 rupees
Decision: as its market price 100 rupees is less than your estimated fair value of 153.8, therefore at its
current price it is undervalued and you would recommend to buy it
Fair value at 22% growth rate
DPS1 = DPS0(1 + g) = 5(1 + 0.22) = 6.1 rupees
Fair value = DPS1 / (Kc g) = 6.1/ (0.239 - 0.22) = 321.05 rupees
Decision: as it current market price 100 rupees is less than your estimate of its fair value 321.05 rupees
therefore it is undervalued at its current market price, and you should buy it.
Herein lies the reason for daily trading in the shares; buyers believe it is undervalued at its current market
price and buy it assuming they are buying it cheap; while the sellers believe the opposite believing that it is
overvalued at its current market price and decide to sell it. The above example showed that for trading to
take place, buyers and sellers must have opposite belief about the current market price of that share.

Risk Adjusted Required Rate of Return vs Expected Rate of Return
Another methodology to make buy or not to buy decision is based on comparing the expected rate of return
with a theoretically correct rate of return, usually that is termed as Risk Adjusted Required Rate of
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

9

Return, and is usually estimated using CAPM model. For example if beta of this stock is 1.2, Rf is 10%,
expected Rm is 20%, then according to CAPM Risk Adjusted Required rate of return for this share is:
Required Kc = Rf + (Rm - Rf) beta
Required Kc = 10 + (20 - 10)1.2
Required Kc = 10 + (10 * 1.2)
Required Kc = 10 + 12
Required Kc = 22%
Now comparing this required Kc with expected Kc you can identify undervalued stock.
Decision rule:
If expected Kc is greater than required Kc, it is under-valued at its current market price and buy it. In this
case expected Kc 23.9% is greater than required Kc 22% therefore you would conclude it is undervalued at
its current price of 100 rupees, and buy it. On the other hand if expected Kc of a share is lower than its
required Kc, it is over valued at its current price , do not buy it or short sell it.
But what is its fair value?
You can solve for fair value by equating required Kc with expected Kc and solving for P
0
. Let us do it .
Required Kc = Expected Kc
Required Kc = (P
1
- P
0
) / P
0
+ DPS
1
/P
0

Required Kc = (118 P
0
) / P
0
+ 5.9/P
0

0.22 = (118 - P
0
+ 5.9) / P
0

0.22P
0
= 123.9 P
0

0.22P
0
+ P
0
= 123.9
1.22P
0
= 123.9
P
0
= 123.9 / 1.22
P
0
= 101.5
So, you have estimated its fair value as 101.5 rupees whereas its market price is 100 rupees, therefore you
would conclude, as you did earlier, that it is under-valued at 100 rupees, and you would buy it .

Use of PE Ratio to Identify Mispriced Shares
Other than Gordon formula analysts use price to earnings ratio (PE ratio) frequently to identify mispriced
shares. This section shows there are 3 types of PE ratios: Trailing Actual PE, Leading Actual PE, and
Leading Intrinsic PE Ratios; it further shows that Leading Intrinsic PE ratio can be bifurcated into 2
components: 1) Tangible PE and 2) Franchise PE. Then you would learn the use of PE ratio in
identifying mispriced shares which are either undervalued or overvalued; and such identification would
allow you to make a buy or not to buy decision about that particular share.
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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PE ratio (price of share / EPS) is also called earning multiplier, and it is commonly used to identify
undervalued shares for buying or overvalued shares for short selling. It is therefore important to
understand the PE ratio more thoroughly. Generally it is believed that relatively high PE ratio for a stock
indicates high growth prospectus for that company, and low PE ratio indicates low growth prospects.
Generally, but not always, growth in companies is expected to translate into growth in share price, that is ,
value creation. But on the other hand high PE ratio may indicate overvalued stock and low PE ratio may
indicate undervalued stock. Then the question arises if high PE ratio means expected high growth of share
price and also over valuation at the current price then how come overvalued share is expected to grow in
price because common sense tells us that overvalued shares should experience a fall in their price not a rise
in their price. Therefore this possible conflicting signal sent by PE ratio must be kept in mind while
interpreting PE ratio.

This conflict in interpretation of PE ratio is resolved by having clarity that Trailing Actual PE ratio is
based upon actual or last years EPS ( EPS
0
) and current share price (P
0
). So, Trailing Actual PE ratio
= P
0
/ EPS
0
. Analytically it is not very useful. Leading Actual PE ratio is estimated by using next year
estimated EPS, that is EPS
1
. EPS
1
is calculated by applying a growth rate on actual last years EPS; and
Leading Actual PE Ratio = P
0
/ EPS
1
. While Leading Intrinsic PE ratio = d / (K
c
g); and it s
calculated from fair value estimates of share price using Gordon model. Leading Intrinsic PE can be
different from leading Actual PE ratio. If leading actual PE ratio is smaller than the leading intrinsic PE
ratio, then market price of share is less than the fair value of that share; and therefore the share is
undervalued at its current market price. Since undervalued assets are the ones you like to buy, therefore,
analysts make a BUY recommendation for such a share. On the other hand if leading actual PE ratio is
greater than leading intrinsic PE ratio then share is overvalued at its current price and analysts make a
SELL recommendation for such shares.
Exercise Three PE ratios:
Trailing Actual PE ratio and Leading Actual PE Ratio, Intrinsic Leading PE ratio
For Example Last years EPS of a Co was Rs 5, and currently its share price (P
0
) in the market is 100 Rs,
and it is expected to have a growth rate 5% calculated as ROE (1 - d). Based on CAPM its Kc (risk
adjusted required ROR) is 13%. It has paid 25% of its profits as cash dividends and that policy is likely to
continue next year. So dividend payout ratio (d) is 25%.
You can calculate 2 actual PE ratios called Trailing PE ratio and Leading PE ratio.
1. Trailing Actual PE ratio is P
0
/ EPS
0
= 100 / 5 = 20 times.
2. Leading Actual PE ratio is P
0
/ EPS
1

Since EPS
1
= EPS
0
(1 + g) = 5 (1+ 0.05) = 5.25 rupees, therefore
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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Leading actual PE ratio = P
0
/ EPS
1

= 100 / 5.25
= 19.04
3. Leading Intrinsic PE Ratio (Also called Justified PE ratio)
Again given below is Gordon valuation formula for fair value of shares, it is also called intrinsic value of
share:
P
o
= DPS
1
/ (K
c
g)
Dividing both sides of equation by expected earnings per share for next year , that is expected EPS
1
,
symbolized here as E1, you get:
P
o
/ E1 = {DPS
1
/ (K
c
g)} / E1
Which can be written as :
P
o
/ E1 = {(DPS
1
/ E1)/ (K
c
g)} .
But DPS
1
/ E1 is dividend payout ratio symbolized as d
1
but as dividend payout ratio is assumed to
remain unchanged therefore d
1
= d
0
of the last year and simply ,d, can be written. so
P
o
/ E1 = d / (K
c
g)
Using the data from example above
P
o
/ E1 = 0.25 / (0.13 0.05)
= 3.125
Note PE ratio of 3.125 times says if EPS next year is 1 Rupee then Share price now is 3.125 rupees, or,
current share price is 3.125 times of expected EPS, or share is trading on a multiple of 3.125 of expected
earnings of that company, or shares earning multiple is 3.125.
Decision rule to decide mispricing of a share is:
if leading actual PE ratio > leading intrinsic PE ratio, share is overvalued.
if leading actual PE < leading intrinsic PE, share is undervalued
In this company leading actual PE ratio 19.04, as calculated above, and it is greater than its leading
intrinsic PE of 3.125 . So you decide that this share is overvalued in the market at its current price.
Therefore it should not be bought, or it should be short sold.
Decomposition of Leading Intrinsic PE ratio
This formula:
P
o
/ E1 = {(DPS
1
/ E1)/ (K
c
g)}
Says that leading Intrinsic PE ratio = dividend payout ratio / difference between required rate of
return and growth rate ; and it is called leading Intrinsic PE ratio because it is derived by using
Gordon formula for intrinsic or fair value of a share. Leading Intrinsic PE ratio can be further broken down
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

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for analytical clarity. Such decomposition of the Leading Intrinsic PE ratio gives us insight about the
reasons which are helping or hurting the valuation of a share.
The Leading Intrinsic PE = Tangible PE + Franchise PE
Leading Intrinsic PE ratio is sum of two components:
1) Tangible PE ratio :
Tangible PE ratio refers to a situation where a company does no reinvestment of its profits in the business;
all NI is given out as cash dividends, and therefore no growth occurs in that companys assets, sales, and
profits. The resulting PE is based on perpetual use of existing assets, and resulting profits from the
productive use of such non growing asset base are also perpetuity, that is, same NI or EPS each future
year. Please note that if dividend payout rate is 1, then 100% of earning is given out as dividends and no
portion of NI is reinvested in the business therefore there is no growth in cos assets is financed from
internally generated equity funds, though such a co can still finance growth in its assets by raising external
equity funds through issuance of more shares and/or by raising more debt capital from bond market or
banks. Growth rate of such a company is calculated as:
g = ROE (1 - d) = ROE ( 1 - 1) = ROE (0) = 0 . In this case its intrinsic leading PE ratio is :
P
o
/ E1 = d / (K
c
g)
=1 / (Kc 0)
=1 / Kc
Let us see how this result is attained. Since DPS = EPS *d, and if all NI is given out as dividends then d
= 1, therefore DPS
1
= EPS
1
*1; therefore Gordon valuation model becomes:
P
o
= DPS
1
/ (K
c
g)
P
o
= EPS
1
/ (K
c
0)
P
o
= EPS
1
/ K
c

Which means EPS is a perpetuity that is discounted at discount rate Kc; and PV of this perpetuity is the
current price of the share. It further means that leading Intrinsic PE ratio is derived by shifting EPS
1
on the
LHS of equation :
P
o
/ EPS
1
= 1 / (K
c
0)
=1 / Kc
And such PE ratio is called tangible PE because it is expected to be the PE if assets of co are not growing
due to non retention of earnings. Therefore expected stream of EPS is constant in all future years due to a
non growing asset base.
2) Franchise PE: It has 2 components , namely Franchise Factor (FF) and Growth Factor (G).
Franchise PE = Franchise Factor * Growth Factor
Franchise PE = { 1 / Kc - 1 / ROE} * {g / (K
c
g)}
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

13


Positive Franchise factor is result of a company earning higher ROE than expected ROR of share holders
(Kc) from projects financed by retention of earnings. The growth factor is PV (present value) of constant
growth rate (g) attained from reinvesting some NI into business and not giving out all of NI as dividends.
Again as you know from corporate finance course that growth rate of a companys OE can translate into
growth rate of its Sales, TA, TL, NI, EPS, DPS, and ultimately growth rate of share price if 5 policies ,
namely, net profit margin, total asset turnover, equity multiplier, dividend payout rate, and number of
shares outstanding are same next year as they were last year. You also know that this growth rate can be
quantified as:
g = ROE * (1 d).
Thus Gordon formula for fair value of share :
P
o
= DPS
1
/ (K
c
g) can be written as : P
o
= DPS
1
/ [K
c
ROE * (1- d)]
And intrinsic leading PE ratio becomes:
P
o
/ E1 = (DPS1/E1) / [K
c
ROE (1 d)]
P
o
/ E1 = d / [K
c
ROE (1 d)]
Now multiply RHS with Kc / Kc
P
o
/ E1 = ( Kc / Kc) [d / {K
c
ROE (1 d)}]
P
o
/ E1 = (1/ Kc) * [(Kc*d) / {K
c
ROE (1 d)}]
Since (1 - d) is called retention ratio , let us show it with symbol b, and thus
d = (1 b), now inserting this value, you get
P
o
/ E1 = (1/ Kc) [(Kc*(1 b)) / {K
c
ROE * b}]
P
o
/ E1 = (1/ Kc) [(Kc Kc*b) / {K
c
ROE* b}]
Adding and subtracting ROE * b in numerator of RHS will give:
P
o
/ E1 = (1/ Kc) [(Kc Kc*b + ROE*b ROE*b) / {K
c
ROE* b}]
and placing ROE* b closer to Kc gives:
P
o
/ E1 = (1/ Kc) [(Kc ROE *b + ROE*b - Kc*b ) / {K
c
ROE* b}]
Bringing divisor {K
c
ROE* b}] under both the terms of RHS
P
o
/ E1 = (1/ Kc) [{(Kc ROE *b) /( K
c
ROE* b)} + { (ROE*b - Kc*b) / (K
c
ROE* b )}]
P
o
/ E1 = (1/ Kc) [1 + { (ROE*b - Kc*b) / (K
c
ROE* b )}]
Taking b as common
P
o
/ E1 = (1/ Kc) [1 + { b (ROE - Kc) / (K
c
ROE* b )}]
Multiplying and dividing the term in large bracket after 1 with ROE we get
P
o
/ E1 = (1/ Kc) [1 + { ROE * b (ROE - Kc) /(ROE * (K
c
ROE* b ))}]
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

14

Since ROE * (1 d) = g, but (1 - d) = b, so you can write ROE * b = g. Now inserting this g in place
of ROE*b you get
P
o
/ E1 = (1/ Kc) [1 + { g (ROE - Kc) /(ROE * (K
c
g)}]
When 1 / Kc is brought inside the bracket, it multiplies with both 1 and with the term right of 1, and you
get
P
o
/ E1 = [1/Kc + 1 /Kc { g (ROE - Kc) /(ROE * (K
c
g)}]
P
o
/ E1 = [1/Kc + { g (ROE - Kc) /(Kc* ROE * (K
c
g)}]
Further simplification gives
P
o
/ E1 = [1/Kc + { (ROE - Kc) /(Kc* ROE)} * {g/ (K
c
g)}]
Bringing denominator (Kc* ROE) under both terms of the numerator , that is under ROE as well as under
Kc gives
P
o
/ E1 = [1/Kc + { (ROE / Kc*ROE) - (Kc /( Kc*ROE)} * {g/ (K
c
g)}]
P
o
/ E1 = 1/Kc + { 1 / Kc - 1 / ROE} * {g / (K
c
g)}
In the above derivation Leading Intrinsic PE ratio is sum of Tangible PE ratio and Franchise PE ratio.
1/Kc is tangible PE due to 100% dividend payout and consequently zero growth.
{ 1 / Kc - 1 / ROE} is called franchise factor. And {g / (K
c
g)} is called growth factor; and { 1 / Kc
- 1 / ROE} * {g / (K
c
g)} is called Franchise PE.

{ 1 / Kc - 1 / ROE} is Franchise Factor, it is is positive if ROE earned by the co on its reinvested profits is
greater than rate of return required by shareholders, Kc; that means retained earnings are invested in such
projects by management that earn ROE greater than the cost of equity capital. Positive franchise factor is
an indication of competitive advantage of this company over its competitors in the products market.

{g / (K
c
g) is growth factor, and it is positive only if cost of equity capital is greater than growth rate,
and also if growth rate is itself positive which is the case only when co does not pay all its NI as dividends
and reinvests some of its NI in the business.
Franchise PE ratio = Franchise factor * Growth factor
Tangible PE = 1 / Kc
Leading Intrinsic PE ratio = Tangible PE ratio + Franchise PE ratio
The product of Franchise Factor and Growth Factor is called Franchise PE ratio, and when it is added to
Tangible PE ratio (that is the PE without growth) then you get leading Intrinsic PE ratio. Comparison of
Leading Intrinsic PE ratio with the Leading Actual PE ratio allows you to make a decision about
overvaluation or undervaluation of a share.
For Example
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

15

For a Co, ROE 15%, dividend payout ratio (d) is 70%, NI expected for next year 100 million rupees,
market value of its equity is 600 million rupees. Shareholders require 20% risk adjusted ROR from share
of this Co , that is, its required Kc.
Please Find: growth rate g; tangible PE, franchise factor, growth factor, franchise PE, and Leading
intrinsic PE, Leading Actual PE ratio, and give your verdict about over or under valuation of this share?
Answers:
g = ROE ( 1 - d) = 15% (1 - 0.7) = 4.5%
Tangible PE ratio = 1 / Kc = 1 / 0.2 = 5
Franchise factor = 1/Kc 1/ROE = 1/0.2 1/.15 = 5 6.67 = -1.67
Growth factor = g / (kc g) = 0.045 / (0.2 0.045) = 0.045 / .155 = 0.29
Franchise PE ratio = franchise factor * growth factor
= -1.67 * 0.29
= -0.48
Leading Intrinsic PE ratio = Tangible PE ratio + Franchise PE ratio
= 5 + -0.48
= 4.52
Double check by applying directly leading Intrinsic PE formula derived from Gordon model:
P
o
/ EPS
1
= d / (K
c
g)
= 0.7 / (0.2 - 0.045)
= 0.7 / 0.155
= 4.52
So we get the same answer, but the former method of bifurcating into tangible PE and franchise PE
provides additional insight. In this case growth factor (0.29) is very small; and franchise factor depicting
the ability to earn ROE higher than Kc is negative ( - 1.67) implying poor competitive advantage of this
company in the products market over its competitors. The overall contribution of franchise PE is
negative towards intrinsic leading PE.
Leading Actual PE ratio = P
0
/ EPS
1
but since per share data is not given therefore you can use total amounts of expected NI of next year
instead of EPS and total MV of equity instead of MV per share , that is P
0
.
Leading Actual PE ratio = MV of equity / NI
1

= 600 / 100
= 6


Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

16

Since for this share
leading actual PE > leading Intrinsic PE
6 > 4.52
Therefore the share of this co is overvalued at its current price in the market and you should not invest in
it; rather wait for fall in its price because overvalued assets are expected to experience decline in their
market price: once that happens then it would be ok to buy it. Another possibility is to attempt to make
profit by short selling this share in the hope of price fall in future.

Please note that in this company ROE was less than Kc, so franchise factor , which is an evidence of
competitive advantage of this co over its competitors, is negative in this company. Though this co has
positive growth prospects, but due to its inability to earn ROE > Kc on reinvested earnings, the growth is
going to be value destroying instead of value creating; and as a result of that its leading intrinsic PE
would be less than its tangible PE. Or in other words, its PE without growth is more than its PE with
growth. That means growth has negative impact on its valuation of shares.

On the other hand for companies with profitable investment opportunities in new projects ROE > Kc, and
their PE with growth is more than their PE without growth. Such companies have positive franchise
factor and therefore their franchise PE is positive resulting in their leading intrinsic PE being higher than
their tangible PE. The lesson is important: It is not growth per se, but profitable growth that creates value
; and leading intrinsic PE would be higher than tangible PE; otherwise growth can turn into a value
destroying phenomenon instead of being a value creating phenomenon.

There are many other methods of doing fundamental security analysis , such as free cash flows model,
equity cash flows model, and accounting valuation model. All these methods require forecasting next few
years income statements and balance sheets, and also require an estimate of Kc. You were exposed to
these models in your Corporate Finance II course in detail.

This brief overview of fundamental analysis of shares was meant to refresh your memory as you already
know most of this material from other courses.

Technical Analysis of Securities
The focus of technical analysts is not on finding undervalued or overvalued shares, nor is it on expected
ROR, rather it is focused on estimating the timing of change in price trend; so in a sense this method
attempt to estimate direction of future price movement. Here it should be emphasized that expected ROR
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17

is also based on future expected price,P
1
, therefore attempt to estimate future expected price movement of
the stock next year is also required by fundamental analysts, but the difference lies in the methodology
used by technical analysts and fundamental analysts.
Technical analysts insist to use only the data generated in stock market due to trading in a share, i.e. price
of share and volume of its trading. This approach ignores fundamental financial data of the company such
as sales, total assets, net income, EPS, DPS, growth rate, beta of share, etc.

Technical analysts try to read pattern of a share price over time; and claims to discover from these past
price patterns future direction of price movement. In short they claim to know when an upward trend in
price would change into a down ward trend and vice a versa. The important word here is WHEN, which
implies this type of security analysis is focused on discovering the timing of change in the direction of
share price or the direction of whole stock market . This approach has an underlying assumption that past
is a good predictor of future, and past price trends are likely to repeat themselves in future. Therefore a
lot of energy is spent on discovering the patterns of share price in the past periods; and then those patterns
are taken as a guide for future price patterns. Practitioner of technical analysis claim to have the ability to
time the exit (sell) and entry (buy) in the market correctly; that is, they claim to know when price would
increase and therefore they can buy before increase in price, and also know when price would fall and thus
can sell before price falls.

It is interesting to note that mostly financial press reports about the performance of stock market using the
technical analysis jargon such as: psychological barrier being broken, ceiling, floor, over-bought market,
oversold market, profit taking, short covering, market sentiments, momentum, breadth of market , depth of
market, market being directionless, etc.

The purpose of both types of security analyses is to identify those stocks which are promising to increase
investors wealth and buy those; and also identify those stocks which are not promising and therefore not
buy those, or if you already have these stocks then sell them, or if you dont have them then short dell
them.

As a security analyst, regardless of your preference for the use of fundament analysis or technical analysis
as the guiding methodology for identifying good buys , your focus on expected ROR is only half the story,
the remaining half is Risk which must also be considered. Risk is uncertainty about expected ROR.
Therefore decision to buy a specific share must be guided by the consideration of its expected returns as
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18

well as its risk. In this course you shall learn in detail about the relationship of risk and return of
securities, and how these are quantified to be used in decision making about buying shares.

Question Two: What Combination to Buy
Common sense answer is not to buy a single security. You know putting all your eggs in one basket is too
risky; similarly putting all your money in one stock is too risky because if basket is damaged due to an
unexpected shock, then you stand to lose all your eggs; similarly if that Co faces bad times then you stand
to lose big if all your money is invested only in sharers of that one company. Therefore it is advisable to
buy a combination of securities, such combination of different shares or securities is called portfolio of
securities. More importantly just any combination of securities wont do; Modern Portfolio Theory tells
that you should preferably buy an efficient combination of securities, or in other words you should try to
build an efficient portfolio.
The following questions are relevant in this regard. What is meant by an efficient portfolio? How to
build an efficient portfolio of securities? Which securities are included in it, and which are not? And those
included, what proportion of your own money (OE) is invested in each of those securities, it is called
weight of a security in your portfolio and is denoted with symbol x ? In an efficient portfolio which
securities have positive weight ( that is you have long position in those securities or you buy those), and
which securities have negative weight (short position , short sell those)? What is Expected ROR of a
portfolio and what is its total risk ? Can total risk of portfolio be divided into components such as
diversifiable risk and non diversifiable risk? For an investor, which risk is relevant while making
investment decision?
It is hoped that this course would help you answer these questions in detail and with mathematical
precision. Such precision is the result of theoretical developments in the Modern Portfolio Theory (MTP)
during 1950s and 1960s due to contribution of Markowitz, Sharpe, Lintner, and Mossin. The application
of MPT in real life took off during 1970s due to the availability of computing power to the investors; and a
new set of industries based on the application of MPT emerged such as mutual funds industry, pension
funds industry, hedge funds industry. In short the whole area of professional money management really
became an industry after wide spread availability of computers made it possible even for small investors to
do the calculation required by MPT.

Question Three: When to Buy or Sell
This is a question about correctly timing your entry in and the exit from the market. Common sense
answer is: buy a stock when its price is low and sell it when its price is high. But in real life how can one
know that todays price is the lowest, and it wont go down further and therefore today is the best time to
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

19

buy. Or todays price is the highest and therefore today is the correct time to sell; and tomorrow or in
future price wont go up further. Is it not possible that price may go down further tomorrow and then you
would regret that you should have waited one more day so you could have bought even cheaper that
particular stock?

This dilemma leads to an interesting question: can anyone correctly time the market exit and entry? This
question also can be posed as: If anyone has the ability to beat the market consistently? Beating the
market means to always buy a stock before its price goes up; and always selling it before its price falls thus
resulting ROR would be higher than ROR on overall market portfolio comprising of all the stocks.
Numerous research studies have shown that no portfolio manager has shown such ability consistently.
Showing this ability once or twice is not the issue; ability to always buy at the lowest price and sell at the
highest price in any given time period is the issue. It means correctly timing your entry and exit from the
market. No investor has shown such ability; be they individual investors, or professional money managers
(portfolio managers) working for financial institutions which have huge research and computational
resources at their disposal.
Here it must be stated that those who do Technical Analysis claim to be able to correctly judge if price is
now too high and therefore it is time to sell (Over Bought Market); or price is now too low and therefore it
is time to buy (Over Sold Market). But empirical testing of their proposed trading strategies (called
technical trading systems) have shown conclusively that no system of trading based on technical rules was
found capable of generating correct buy and sell signals for their users on a consistent basis, though some
research studies have found support for the momentum based trading strategies where a winner stock in
past period seems to be a winner in the next period, and a looser in past period was found to be a likely
looser in the next period as well; but even in this case a universal agreement about acceptable period for
such comparison is non- existent because I can use a one week period and you can use a one month or one
year period, or a one day period.

Generally the issue of timing is more relevant for the short term traders who frequently buy and sell almost
on daily basis. Presently, due to ease in order execution as a result of information technology revolution,
even frequent intra-day trading is becoming easier and popular.

There is strong support in research literature for the Buy and Hold strategy over a reasonably long period
of time. Such long term investors are more likely to be better-off in terms of increase in their wealth than
the short term traders. Nature of corporate shares is such that these are securities with no maturity , that
is, theoretically their maturity is infinitely long period of time; therefore holding period envisioned by
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

20

investors should be a very long period. But unfortunately even the professional money managers
working for mutual funds, pension funds, treasury departments of banks, etc, are evaluated on quarterly
basis. This short term performance evaluation culture results in a bias in favor of showing good results
every quarter and therefore leads to excessive attention to market timing and resultant more frequent
trading than is warranted by common sense. Probably the only beneficiary are brokerage-houses because
by frequent trading they stand to earn commission fee for executing the order of the investor on the
exchange floor.

Therefore if time horizon for investing in shares is very long then the question when to buy has a
common sense answer: today. Because it does not matter much that you wait a few more days in the hope
of buying at lower price if your investment horizon (expected holding period) is next 20 years. Similarly
if a long term investor has decided, say after holding a share for 15 years, to liquidate her holding due to
certain personal circumstances then it is not a matter of great importance to wait for a few more days
before selling her share holding in the hope of getting higher selling price: today also is the right answer
for her.

Just looking at the value of major stock indices such as KSE-100 index (Pakistan) or Dow Jones 30 index
or S&P 500 index (USA) over the last 50 years gives very strong evidence in favor of buy and hold
strategy while doing investment in corporate shares. Compound annual growth rate of all these indices has
been in double digits for the last half a century; and no other security or investment instrument has give
such high rate of return over such a long period of time. Therefore commonly held belief that investing in
corporate shares can make you very wealthy is not misplaced; but for that to happen investor should have
the patience of holding her investment for long period of time: you should buy shares not for yourself but
for your grand children. Now this approach to investing in shares is not stated in such stark terms by text
book authors, nor is it promoted by professional investment advisers, probably for good reasons of self
interest as their bread and butter is linked with investors indulging in frequent buying and selling of shares.

Remember as soon as you get into a mind set of becoming rich overnight and chose shares as the vehicle to
attain that goal you are in the arena of gambling and out of arena of professional investing. Then the only
relevant question is why select share market to satisfy your urge to gamble? There are available better,
easier, and cheaper modes of doing gamble or playing games of chance than the share market.
What This Course Aims to Teach
This course is aimed at learning the answers to the first two questions: 1) What to buy, and 2) what
combination to buy; because these are answerable questions. The third question ( when to buy?) is a
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

21

question about the market timing and that is not answerable; therefore this course wont pretend to teach
the answer to the third question.



RATE OF RETURNS
In this course the word rate of return (ROR) would be used frequently. It is important to be very clear
about various types of rate of returns on shares
Actual ROR , Historic ROR, Realized ROR, Ex-post- Facto ROR
On shares of companies, actual percentage rate of return (ROR) for one period (usually one year)
investment is:
Actual ROR = Realized capital gains yield + Realized dividend yield
realized capital gains yield is (selling price - buying price ) / buying price; and realized dividend
yield is cash dividend per share received / buying price.
This actual ROR needs no theory, it is a historical fact, and it is actually available for past periods for all
the shares, so there is no argument about it.
Example: Realized ROR
For example if you bought on January 1 a share of MCB at 200 and received during the year DPS of Rs 5,
and sold the share after one year on December 31 for Rs 250. Then your actual, or realized, historic, or ex-
post facto ROR is:
Realized Capital Gains Yield = (250 - 200) / 200 = 25%
Realized Dividend Yield = 5 / 200 = 2.5%
Realized ROR = 25% + 2.5% = 27.5% per year.
Since all of this has HAPPENED, it is a fact, there is no ambiguity about it, and this information is
available to all investors, therefore actual or realized RORs are not the issue; and more importantly these
RORs are no guarantee, or even a good reliable guide, for future ROR from the same share for the next
period or next year.
Having said that it must be acknowledged that the tendency to project the past into future and making
expectation about future ROR of a stock based upon its past RORs is wide spread. Probably it is a
reflection of human inclination, as depicted in many other spheres of life, to believe that the patterns of
past would continue to survive in future. It is likely that abhorrence to change and a fear of unknown is
the basis of such thought patterns.
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In any case there is no reason to believe that a share which has given 60% ROR last year would give close
to 60% ROR next year as well; rather it has happened many times that a co reporting very high ROE in
one year, went bankrupt the next year.




Expected ROR , Future ROR, Ex-ante ROR
Investors making investment decision today are interested in expected ROR , or ex-ante ROR, which they
hope to earn after completion of a holding period, usually one year. There are theories about expected
ROR, and since it is a future oriented number therefore it has to be estimated by investors before making
the investment decision. Usually such estimation is done for one period which is usually next one year.
The skill of security analyst lies in correctly estimating expected ROR for the next year, and this skill of a
security analyst is judged by the accuracy of her estimated expected ROR when it is compared after one
year with the actually realized ROR from that particular stock. Formula for expected ROR is very similar
to formula for actual ROR:
Expected ROR = Kc = Expected dividend yield + expected capital gains yield
Expected dividend yield = Expected dividend per share next year / current price
Expected dividend yield = DPS
1
/ P
0

Expected capital gains yield = (expected price next year current price )/ current price
Expected capital gains yield = (P
1
- P
0
) / P
0

Note that estimating the ROR for next year requires estimating 2 items:
a) P
1
, that is price of the share after one year.
b) DPS
1
, that is expected cash dividend per share that stock is likely to give to the stockholders during next
year.
Since both these items are estimated for the next year therefore expected ROR is as good as these
estimates are.
Expected ROR = ( DPS
1
/ P
o
) + (P
1
- P
o
)/ P
o

In this expression P
o
refers to current price of share which is available and needs no estimation.
Please note that estimating DPS for next year requires estimating EPS for the next year, which in turn
requires estimating NI for the next year, which ultimately requires estimating income statement for the
next year. As Income statement for the next year cannot be estimated without estimate of an asset base,
therefore it inevitably requires estimation of balance sheet for the next year as well. These forecasting
exercises you have done in your previous courses such as Corporate Finance II.
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23


Estimating P1 (expected price after one year) is more tricky. If you decide to apply a growth rate on
current price then it gives P
1
= P
o
(1 + g); in this formulation the dispute is about the right methodology
for estimating growth rate of share price. Mostly analysts do not seem to agree one on growth rate for a
company and their individual growth rate forecasts tend to vary greatly. Remember under assumption of 5
major policies remaining unchanged next year, this growth rate can be ROE (1 - d). But this condition of
no-change in 5 policies is rather restrictive and therefore unrealistic in most cases because keeping the
management performance un-changed in 5 major areas of performance is a tall order. To be specific, for
ROE (1 - d) to be the growth rate in share price, performance in the following 5 areas should be same as
last years performance , i.e., no change in
1) net profit margin ,NI/S, meaning ability to extract profit from sales revenues is constant; if last year it
was 3% of sale , next year it should also be 3% of sales.
2) total assets turnover, S/TA, meaning productivity of assets in generating sales should be constant, if last
year 1 rupee of asset was helping generate 2 rupees of sales then next year it should remain the same.
3) financial leverage, TA/OE, it means capital structure, and therefore financial risk, remains unchanged; if
last year it was 5, then next year it should be 5 as well.
4) dividend payout ratio (d) , DPS / EPS, percentage of NI given out as cash dividend is constant; if last
year a co gave 30% of its NI as cash dividend then next year also it should give 30% of NI as cash
dividend.
5) number of shares outstanding unchanged, meaning no new share offering as bonus shares or stock
dividends, no new share offering as right offering to existing shareholders to raise equity funds for co, no
new share floatation as a seasoned offering to general public to raise equity funds; it also means no share
repurchase next year by the co so that number of shares outstanding remain the same next year as they
were last year.
Please note keeping these 5 policies constant also means ROE next year would be same as last year
because ROE = NI/S * S/TA * TA / OE.
In the data given above ROE = 3% * 2 * 5 = 30% , since 3 component of ROE would be same
next year under policy constancy assumption therefore ROE next year would also be 30% as it was last
year. But you must be clear about the fact that EPS wont be same next year as it was last year because
EPS = NI/S * S/TA * TA / OE * OE / # shares, as S , TA , and OE cancel out
EPS = NI /# shares
Since OE/# shares is called BV per share therefore you can write:
EPS = ROE * OE/# shares
EPS = ROE * BV per share
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

24

and since BV of OE in balance sheet would increase next year due to profits or OE would decrease due to
losses, therefore BV per share would be different next year as compared to the previous year. Also DPS
next year wont be the same as DPS last year because DPS = EPS * d, though d, dividend payout ratio,
would be same next year as in last year ; but as EPS next year would be different than last years EPS ,
therefore DPS next year would come out different than the DPS of the previous year.
With these 5 policies constancy restrictions in place, you can estimate:
g = ROE (1 - d)
P
1
= P
o
(1 + g)
DPS
1
= DPS
o
(1 + g),
Example: Expected ROR
For example current price of a companys shares is Rs 50, Its ROE last year was 10% and its dividend
payout ratio (d ) was 50%, and it had paid Rs 2 DPS last year. Then you would conclude that:
growth rate of its OE is= ROE (1 - d) = 10% (1 - 0.5) = 5%.
It has paid Rs 2 DPS in the most recent year, i.e. DPS
o
, therefore you would estimate its next year DPs as
: DPS
1
= DPS
o
(1 + g) = 2(1 + 0.05) = 2.1 Rs. And estimate for its next years share price is:P
1
= P
o
(1
+ g) = 50 (1 + 0.05) = 52. 5 Rs
And based on these estimates you would estimate expected ROR for the next year :

Kc = (DPS
1
/ P
o
) + (P
1
P
o
) / P
o

Kc = ( 2.1 / 50) + (52.5 - 50) / 50
Kc = 0.042 + 0.05
Kc = 0.092 or 9.2% per year
This is your estimate for the expected ROR from this share for the next year if you bought it at todays
price of Rs 50.

One approach used to estimate P
1
is estimating next years EPS and multiplying it with current PE ratio of
the Company. Another approach of estimating P
1
is to estimate next years BV per share (OE / number of
shares) and multiplying it with current MV to BV ratio of the Company.
If you want to use growth rate and do not want to make restrictive assumption of the constancy of 5
policies, and want to use such growth rate to estimate P
1
, one approach to estimating growth rate is to use
GNP growth rate as proxy for the growth rate of share price, such GNP growth rate estimates are easily
available for any country. It is important to note that there is no single correct answer or approach
available to estimate the requisite inputs for estimating expected ROR of a share for the next year.
Therefore different analysts estimate different expected ROR for a share; and mostly this difference in
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

25

opinion is due to estimating different growth rate for that company based on their own analysis of the
prospects of that company.

Actual (and also expected) ROR per year for Multi-period holding period
For example, you bought on January 1 , 2005 a share of MCB at 100, and in 2005 it gave you cash
dividends of Rs 4, in 2006 cash dividends of Rs 6, in 2007 cash dividends of RS 3, in 2008 cash dividends
of Rs 8, in 2009 cash dividends of Rs 7. At the end of 2009 you sold the share on December 31 for Rs
250. What was your realized annual ROR from this investment ?
First put the Cash flows on time line:
Time 0 - 100
Time 1 4
Time 2 6
Time 3 3
Time 4 8
Time 5 7 + 250 = 257, assuming dividends are given by the co at the end of each year.
Use CASH mode of FC -100 and enter in data editor all these cash flows , and solve IRR. You get
23.93% per year. Note: underlying assumption in this solution, like all IRR calculations, is that interim
cash flows were reinvested at IRR; it means DPS of 4, 3, 6, and 8 were reinvested to earn 23.93% per year;
and it must be stated that such assumptions , at best, are unrealistic in real life. One can apply this
methodology for a future holding period of next 5 years as well if DPS for each of the next 5 years is
estimated and an estimate of P5 (price after 5 years) is also made. But making such precise forecasts for
extended periods in future is not realistic and practically useable in real life. In practice the whole exercise
boils down to an attempt to estimate DPS
1
and P
1
and based on these numbers estimating an expected Kc
for the next year.
Generic ROR on Various Investments
For one year investment, ROR on any instrument has 2 component, namely, an income yield and a capital
gains yield. Income yield is due to cash paid by that instrument (security or asset) to the investor. For
shares this cash payment is called cash dividends, for bonds it is called interest payment, on commercial or
residential rental property it is called rent income; but for investment in paintings, or plots of land, or
jewelry there is no cash income. The second component of ROR , namely, capital gains yield is due to the
increase in price of that investment since you bought it, it may be a capital loss also if price has declined
since you bought that investment. In case of plots of land, jewelry, antique furniture, and paintings all the
ROR is from capital gains yield as there is no income yield from these assets. But in case of investments
in share, bonds, and residential or commercial rental property cash income in the form of dividends,
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2014. Dr. Sohail Zafar.

26

interest, or rent gives rise to an income yield. In case of investment foreign currencies, if you kept it in a
bank deposit account you may earn interest as well (your interest yield) along with increase in value of
foreign currency against local currency ( your capital gains yield in local currency). For example ROR on
one year investment in shares is:
(selling price purchase price) / purchase price + cash dividends received / purchase price.
ROR on one year investment in bonds is:
(Selling price purchase price) / purchase price + interest received / purchase price
ROR on one year investment in residential or commercial rental property is:
(Selling price purchase price) / purchase price + rental income / purchase price
ROR on one year investment in a plot of land is:
(Selling price - purchase price) / purchase price
ROR on one year investment in Paintings:
(Selling price - purchase price) / purchase price
ROR on one year investment in jewelry is:
(Selling price - purchase price) / purchase price
Note: Selling price does not mean you have to actually sell the asset, it means if you had sold it at the end
of the year then at this price you would have sold it because it was the prevailing price at the end of the
year. But ROR is still there and can be calculated even though you decided not to sell your investment.