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LECTURE 1
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
about investment in corporate assets such as NWC and FA
(investing decisions in corporate finance); nor is it about
investment in an a country’s or province’s infrastructure such
as roads, bridges, schools, hospitals, etc (investment as used
by economists); nor is this course 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 Pakistan’s securities market.
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
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.)
WHEN TO BUY
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 practice how can one know that today’s price is the
lowest, and it won’t go down further and therefore today is
the best time to buy. Or today’s price is the highest and
therefore today is the correct time to sell; and tomorrow or in
future price won’t 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
consistently time the market (exit and entry) correctly? This
question also can be posed as: If anyone has the ability to
beat the market consistently? Beating the market means to
buy a stock before its price goes up and selling it before its
price falls. Numerous research studies have shown that no
10
(P1 – Po ) / Po + (DPS 1 / Po )
(52.5 - 50) / 50 + ( 2.1 / 50)
0.05 + 0.042
0.092 or 9.2% per year would be your estimate for the
expected ROR from MCB shares for the next year if you
bought it at today’s price.
Another approach used to estimate P1 is estimating next
year’s EPS and multiplying it with current PE ratio of the
Company. Another approach of estimating P1 is to estimate
next year’s 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 to estimate P1 , 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.
Actual (and also expected) ROR per year for
Multiperiod 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
10
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.
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, and paintings all the ROR is from capital gains yield.
But in case of investments in share, bonds, and residential or
commercial rental property cash income in the form of
dividends, interest, or rent gives rise to an income yield. For
example ROR on one year investment in shares is:
(selling price – purchase price) / purchase price + cash dividends received
/ purchase price.