PORTFOLIO

EVALUATION AND
PORTFOLIO REVISION
• Adithya Baliga
• Keval Limbani
 Portfolio Evaluation
• Evaluation of the performance of the
portfolio
• Process of comparing the return earned
on a portfolio with the return earned on a
benchmark portfolio.

• Portfolio evaluation – two functions

1. Performance measurement.
2. Performance evaluation.
• Performance measurement – accounting
function which measures the return
earned on a portfolio during the
investment period.

• Performance evaluation – states

whether the performance was superior
or inferior, whether the performance
was due to skill or luck.
 Need for Evaluation
• Self – evaluation
• Evaluation of portfolio managers
• Evaluation of mutual funds

• Evaluation Perspective –
Transaction View
Security View
Portfolio View
 Return ???
• The change in the value of the
portfolio over the holding period +
any income earned over the period.

• In case of mutual funds, cash inflows

and outflows may occur.
 Return on Mutual Funds

• Rp = (NAVt – NAVt-1 ) + Dt + Ct
NAVt-1
NAVt = NAV at the end of holding period
NAVt-1 = NAV at the beginning of holding period
Dt = Cash disbursements during the holding period
Ct = Capital gain disbursements during the holding
period.
 Risk Adjusted Returns
• Risk Free rate.
• Risk Premium.

• A higher ratio indicates better

performance.

• 2 methods to measure the reward

per unit of risk.
 Sharpe Ratio
• Developed by William Sharpe
• Also known as reward to variability ratio.

• Ratio of risk premium to variability of risk

measured by standard deviation of return.

SR = Return on Portfolio – Risk free return

Standard Deviation of portfolio return
 Treynor Ratio
• Developed by Jack Treynor
• Also known as reward to volatility ratio.

• Ratio of reward to variability of risk

measured by portfolio βeta.

TR = Return on Portfolio – Risk free return

Portfolio βeta
Problem:
Fund Return (%) Std Beta
Deviation
(%)
A 12 18 0.7
Z 19 25 1.3
M 15 20 1.0
(Market
Index)

Risk – free return is 7

percent
• Both models relate the return to risk.
• Sharpe uses total risk as measured
by standard deviation.
• Treynor employs systematic risk as
measured by the Beta co-efficient.
• In a diversified portfolio,
unsystematic risks are diversified –
thus β is relevant.
• In an undiversified portfolio, total risk
measure is appropriate.
 Differential Return
• Developed by Michael Jenson.
• Known as Jenson measure

• Tries to measure the differential between

actual return and the expected return on
a portfolio.

• CAPM model is used in this methodology.

 E(Rp) = Rf + βp (Rm – Rf)

E(Rp) = Expected portfolio return

Rf = Risk free rate
βp = Systematic risk of the portfolio
Rm = Return on market index

Differential return is calculated as follows –

αp = Rp – E(Rp)
Problem:
• Consider funds A and Z. The actual
returns realized from the two funds are
12% and 19% respectively with Beta
co-efficient 0.7 and 1.3 respectively.
The market return is 15% and the risk
free rate is 7%.

• Negative value of alpha indicates

inferior performance and vice versa.
 Conclusion – Performance
Evaluation
• Mechanism for identifying weakness
in the investment process.
• To improve the deficient areas.
• Serves as a feedback for improving
portfolio management process
 PORTFOLIO REVISION
• The financial markets are continually changing. In this
dynamic environment, a portfolio that was optimal when
constructed may not continue to be optimal with the
passage of time.

• It may have to be revised periodically so as to ensure

that it continues to be optimal.
 NEED FOR REVISION

• Change in financial markets

• Changes in investors position

 Factors related to changes
in investors position
• Availability of additional funds for investments

• Change in risk tolerance

• Change in investment goals

• Need to liquidate a part of the portfolio to

provide funds for some alternative use.
 CONSTRAINTS IN
PORTFOLIO REVISION
• Transaction cost

• Taxes

• Statutory stipulations

• Intrinsic difficulty
 PORTFOLIO REVISION
STRATEGIES

• Active revision strategy

• Passive revision strategy

 FORMULA PLANS
• Certain mechanical revision techniques or
procedures have been developed to enable the
investors to benefit from the price fluctuations in
the market by buying stocks when prices are low
and selling them when prices are high.

• These techniques are referred to as FORMULA

PLANS.
DIFFERENT FORMULA PLANS

• Constant Rupee Value Plan

• Constant Ratio Plan

• Dollar Cost averaging

 SIM
• Need- To simplify the mathematical
calculations of Markowitz model
• Assumption made- The co-movement
between stocks is due the single
common influence by market
performance
• Measure- Relate the stock return to the
return on a stock market index.
 Computation ease
• The single-index model compares all securities
to a single benchmark
• Substantially reduced the number of required
inputs when estimating portfolio risk.
• Instead of estimating the correlation between
every pair of securities, simply correlate each
security with an index of all of the securities
included in the analysis
 The Efficient Frontier
• A fifty security portfolio requires the calculation of 1225 co
variances to forecast portfolio variance. Thousands of stocks
exist, and a pair wise comparison of them all would be a very
unwieldy risk. To get around this problem, the single index model
compares all securities to a benchmark measure, the market
portfolio.

• The single index model relates security returns to their betas,

thereby measuring how each security varies with the overall
market. (Instead of how each security varies with respect to each
other)

• Beta is the statistic relating an individual security’s returns to those of the market
index.
 Security’s Beta
A security’s beta is calculated by:

COV ( R% %
i , Rm )
βi =
σ m2
where R% = return on the market index
m

σ m2 = variance of the market returns

R% i = return on Security i

• Beta is a measure of how a security moves

relative to overall market movements.

26
 Portfolio Statistics
• Beta of a portfolio:
n
β p = ∑ xi β i
i =1

• Variance of a portfolio:

σ = β σ +σ
2
p
2
p
2
m
2
ep

≈β σ 2
p
2
m

27
 Single Index Model
A broad stock market index is
assumed to be the single, common
factor for all securities
(ri − rf ) = α i + β i (rm − rf ) + ei

α i = expected return of stocki if market’s excess

return is zero
β i(rm - rf) = component of return due to market
movements
ei = component of return due to unexpected firm-
 Single Index Model
• SCL notation:
Ri – T = [βim (Rm – T)] + [αi + ri]

[βim (Rm – T)]->systematic component of excess return

[αi + ri]->unsystematic component of excess return

Ri –holding period return on security I

T -riskless rate of interest
Rm - holdingperiod return on the market portfolio
Βim - ratio of change in i’s excess returns to a change in the market portfolio
αi - excess return on the security with an excess return of zero on market portfolio
ri - deviation from αi
 Decomposing Total Risk
• Single Index Model for a portfolio of stocks:

R = α p + β p Rm + e p
p
• The variance of Rp is:

• As the number of stocks 2 increases,

2 the last term becomes
less important asσ ap result
2
= β pσofm +
2
σ (e p )
diversification
• Total risk = systematic risk + diversifiable risk
Security Characteristic Line
• The comparison of a stock's excess return can
be plotted against the market's excess return
on a scatter diagram using linear regression
to construct a line that best represents the
data points.
• This regression line, called the security
characteristic line (SCL), is a graph of both
the systematic and the unsystematic risk of a
security. The intercept of the regression line
is the alpha of the security while the slope of
the line is equal to its beta.
Security Characteristic Line (SCL)

Insert Figure 16-11 here.

Beta can be estimated from historical data using the market model
- Linear Regression of Market Proxy (S&P 500) and Security excess
returns

Insert Figure 16-12 here.

 The Single Index Model

• The intercept from the linear regression (the market

model) is know as alpha (also know as the Jensen
Index), and is sometimes used as a measure of (risk-
adjusted) performance
– Positive alpha: return earned is greater than expected based
on risk borne
– Negative alpha: return earned is smaller than expected
based on risk borne
– More useful when evaluating portfolios (like mutual funds)
• The slope from the linear regression is beta. It is
the ratio of the change in the security’s excess
returns to a change in the market portfolio.
- Beta value greater than one indicates that if the market
portfolio’s excess returns is larger than expected
- Beta value less than one indicates that if the security’s
excess return is larger than expected
Factor models of security
returns
• Goal- Identify the factor/factors in the
economy and the sensitivities of security
returns to movements in these factors
• Looks at the effect of only one given factor
or a particular set of factors on a group of
stocks
• Macroeconomic factors considered
• E.g.: GNP, inflation rate, interest rates,
industrial production
 Single factor model
• Mathematical representation
Ri = ai + biF+ ei -------------------------------------- (1)

Where

Ri = the (uncertain) return on security i

ai ,bi = Constants
F = the (uncertain) value of the factor
ei = the (uncertain) security specific return
• If the value of the factor is zero, the return on
security would be ai + ei

• The expected value of the security specific

component of return is assumed to be zero.

• This requires that ai include the expected portion

of the non-factor related return.
The expected return on security i according to the
single- factor model is :
Ei = ai + bi Ef ------------------------------------(2)

Where:
Ei = expected return on security ‘i’
Ef = the expected value of the factor while the standard
deviation can be determined from:
σ2i = bi2 σ2f + σ2€i ------------------------------------(3)

Where:
σi = the standard deviation of return on security i.
Ri – T = αi + βim (Rim -T) + ri -------------(4)

Ri = T + αi + βim (Rim -T) + ri

Ri = T + αi + βim Rim -T βim + ri
Ri =[ αi + T(1- βim )] + βim Rm-T + ri -------(5)

The term ai and bi of the single factor model can be

interpreted to be equal to [ αi + T(1- βim )] and βim
respectively.
Example: Assume a security i has αi = +5% and
βim = 0.9. Given a risk free rate of 8%, find the
characteristic line of this security .
Ri – 8% = 5% + 0.9 (Rim -8%) + ri

which can be rewritten as follows:

Ri = 8% + 5% + [(Rim -8%) x 0.9+ ri ]

Ri = 8% + 5% + [(Rim - 0.9) – (8% x 0.9)+ ri ]

Ri = 5.8% + 0.9 Rim + ri

Thus, the characteristic line for security i is similar to
a single – factor model equation where the factor is
the return on the market portfolio (that is, F=Rm), and

ai = 5.8%, βim = 0.9 and e i = ri.

 MULTIPLE- FACTOR MODEL
A multiple factor model is needed in a complex world as
the security returns are affected by a number of factors
like:
• Expectations about future levels of real GNP
• Expectations about future real interest rates
• Expectations about future levels of inflation, etc.
While they impact on the return on the market portfolio,
these factors may impact on the returns on different
securities differently.
The general form of a factor model:
Ri = ai + bi1 F1 + bi2 F2 +..... bim Fm + ei
Where:
m = the number of factors with the assumption that:
i) The expected value of each security specific is zero.
ii)Security-specific returns are uncorrelated wit factors
iii)Security- specific returns are uncorrelated with each
other.
This is termed as the M-factor model. The portfolio
can emphasize one or more of the factors by
selecting portfolio weights in a particular way.
SINGLE PERIOD VALUATION
MODEL
 P0 = D1/(1+r) + P1/(1+r)

 P0 = D1/(r-g)

 r = (D1/ P0) +g
• ABB Company’s equity
share is expected to
provide a dividend of Rs2
and fetch a price of Rs 17 a
year hence. What price
would it sell for now if
investors’ required rate of
return is 12 percent?
 P0 = D1/(1+r) + P1/(1+r)
=2/(1.12)+17/
(1.12)
=16.95
• The expected dividend per share on
the equity share of Roadking Ltd is
Rs 2. the dividend per share of
Roadking Ltd has grown over the
past five years at the rate of 5% per
year. This growth rate will continue
in future. Further, the market price
of the equity share of Roadking Ltd,
too, is expected to grow at same
rate. What is a fair estimate of the
intrinsic value of the equity share of
Roadking Ltd if the required rate is
15%?
P0 = D1/(r-g)

=2/(0.15-0.05)

= Rs 20
• The expected dividend
per share of Vaibhav Ltd
is Rs 5. the dividend is
expected to grow at the
same rate of 6% per
year. If the price per
share now is Rs 50, what
is the expected rate of
return?
r = (D1/ P0) +g

= (5/50)+0.06

= 16 percent.
• Formulae:
• Po=Di/(i-g)
• V=D1/(1+k)+D2/(1+k)^2+D3/(k-g2)/(1+k)^2
• D1=(EPSo)(1+g)(D/P )
ratio

• Dn=Dn-1(1+gn-1)
• g=ROE(1-D/P ratio)
• Po=€Do(1+g1)^i/(1+k)^i + Dn(1+g1)^i(1+g2) /((k-g2)
(1+k)^n)
• The expected earnings per
share is Rs. 3 and dividend Rs.
2 respectively. If the required
rate of return is 15%, what
should be the share price
assuming g= 0%, 5%, 10%

• Given: D =2, i=0.15

i

a)g=0
b)g=0.05
c) g=0.10
Formula:Po=Di/(i-g)
A) Po=Di/(i-g)
= 2/(0.15-0)= 13.33
B) Po=Di/(i-g)
=2/(0.15-0.05)=20
c) Po=Di/(i-g)
=2/(0.15-0.10)=40
• Novex Industries, a firm is operating
in a mature industry and is expected
to maintain a constant dividend
payout ratio and constant growth rate
of earnings. Earnings were Rs. 4 per
share in the recently completed fiscal
year. The dividend payout ratio has
been constant 50% in recent years
and is expected to remain so. Novex’s
return on equity is expected to remain
15% in the future, and you require
12% return on equity.
Calculate the current value of Novex’s
equity, using the DDM, assuming that
noVex will grow at 20% for the next 2
years, returning in the third year to
the historical growth rate.
V=D1/(1+k)+D2/(1+k)^2+D3/
(k-g2)/(1+k)^2
• Given k=0.12
D1=(EPSo)(1+g)(D/P ratio)
= 4*(1+0.2)(0.5)= 2.4
D2=D1(1+g1)
=2.4(1+0.2)=2.88
D3=D2(1+g2)
=2.88(1+0.075) where g2=ROE(1-D/P
ratio)

= 0.15(1-0.5)= 0.075
Value=2.4/(1+0.12)+ 2.88/(1+0.12)^2
+ 3.096/(0.12-0.075)/(1+.12)^2

= (2.4/1.12) +(2.88/1.2544)
+(3.096/0.045/1.2544)
=59.29
• TCL is showing a dividend
growth rate of 20%. After 5
years, its expected to
slowdown and come to
normal growth rate of 6%. Its
required rate of return is
15% and its present dividend
is Rs. 0.50 per share. What is
the current value of its stock.
Formula: Po=€Do(1+g1)^i/
(1+k)^i + Dn(1+g1)^i(1+g2) /
((k-g o
2)(1+k)^n)
Given: D =0.50, g =20, g =6, k=15, n=5
1 2

Po=€ 0.5(1+0.2)^5/(1+0.15)^5 + 0.5(1+0.2)(1+0.06)^5/

((0.15-0.06)(1+0.15)^5)
= 0.5(1+0.2)^1/(1+0.15)^1+ 0.5(1+0.2)^2/
(1+0.15)^2+ 0.5(1+0.2)^3/(1+0.15)^3+ 0.5(1+0.2)^4/
(1+0.15)^4+ 0.5(1+0.2)^5/(1+0.15)^5+
0.5 (1+0.06)(1+0.2) ^5/((0.15-0.06)(1+0.15)^5)
= 0.522+0.544+0.568+0.598+0.619+7.285
=10.136
The current value of the stock should be Rs. 10.14
1. Zero Growth (Constant Dividend) Model

A. Solving for Price:

V = D/k, where D = dividend and k = required return

What would an investor be willing to pay for a stock if

she expected to receive a dividend of $2.50 each year
indefinitely and her required return is 15%?
D $ 2.50
k 15.00% \
V? ( $ 16.67 )

B. Solving for Return: k = D/V

What rate of return would an investor expect if the
current price of a stock is $119 and she expected the
firm to pay a constant dividend of $4/year?
V $ 119.00
D $ 4.00
k? (3.4%)
 2. Constant Growth Model
A. Solving for Price:
V = D0(1+g)/k-g = D1/(k-g) , where D0 = current
dividend, k = required return, and g = growth rate
What would an investor be willing to pay for a stock if she
just received a dividend of $2.50, her required return is
15%, and she expected dividneds to grow at a rate of 5%
per year.
D0 $ 2.50
k 13.00%
g 4.00%
V? ( $ 28.89)

B. Solving for Return: k = D0(1+g)/V + g = D1/V + g

What is my expected return on a stock that costs $26.50,
just paid a dividend of $2.50, and has an expected growth
rate of 5%?
D0 $ 2.50
V $ 26.25
g 5.00%
k? ( 15.00%)
 3. Non-Constant Growth Model
A. Solving for Price: This model involves the computation of
year-to-year dividends which are then dicounted at the
investors required rate of return.

What would an investor be willing to pay for a stock if she just

received a dividend of $2.50, her required return is 15%, and
she expected dividneds to grow at a rate of 10% per year for
the first two years, and then at a rate of 5% thereafter.

Step 1:
Compute the expected dividends during the first growth
period.
g 10.0%
D0 $ 2.50
D1 $ 2.75
D2 $ 3.03
Step 2 :
Compute the Estimated Value of the stock at the end
of year 2 using the Constant Growth Model
D2 $ 3.03
k 15.00%
g 5.00%
V2? $ ( 31.76)
 Step 3:
Compute the Present Value of all expected cash
flows to find the price of the stock today.
Cash Flow PV( at 15% )
1 D1 $ 2.75 $ 2.39 2
2 D2 $ 3.03 $ 2.29 3
V 2? $ 31.76 $ 20.88
V0 ? $ 25.56
 CAPM Model
The capital asset pricing model (CAPM), as the name
suggests, is a theory that explains how asset prices are
formed in the market place. The capital asset pricing
model provides the framework for determining the
equilibrium expected return for risky assets.
Capital market theories, also referred to as asset
pricing theories, deal with how asset prices are
determined if investors behaved the way Markowitz’s
portfolio theory suggests. A price reflects the expected
return and risk associated with an asset.
 Assumptions of CAPM
• The investor’s objective is to maximize utility of
terminal wealth.
• Investors make choices on the basis of risk and
return.
• Investors have homogenous expectations of risk
and return.
• Investors have identical time horizon.
• Information is freely and simultaneously available to
investors.
• There is a risk-free and investors can borrow and
lend unlimited amounts at the risk-free rate.
• There are no taxes, transaction costs, restrictions
on short rates, or other market imperfections.
• Total asset quantity is fixed and all assets are
marketable and divisible.
• According to the capital market theory, the market compensates or rewards for systematic
risk only. The level of systematic risk in an asset is measured by the beta coefficient (β). The
CAPM links beta to the level of required return. Graphic depiction of the CAPM—the expected
return-beta relationship—is referred to as the Security Market Line (SML).
E (ri) = rf + β [E (rm) – rf ]

Expected return = Risk-free return + (Beta × Risk premium of market)

on security i = Intercept + (Beta × Slope of SML)
The more familiar form of the SML:
E (ri) – rf = β [E (rm) – rf  ]

Risk premium on security I = Beta × Risk premium of market

where E (ri) = Expected or required rate of return on asset i
rf = Risk-free rate of return, vertical axis intercept
β = Systematic risk of the asset, beta
E (rm) = Expected return on market portfolio
 APT MODEL- Intro. and
Meaning
 Stephen Ross in 1976

 The theory predicts a relationship between the returns

of a portfolio and the returns of a single asset through
a linear combination of many independent macro-
economic variables.
 The Arbitrage Pricing Theory (APT)
• The Arbitrage Pricing Theory (APT) is an alternative model of
asset/security pricing. The APT is based on the concept of
arbitrage. By eliminating arbitrage opportunities, the arbitragers
help in developing the state of capital market efficiency in which
all riskless securities yield the same expected return.
• Multifactor Linear Model
• Another useful way of explaining the APT is that it relates the
returns of security within a multivariate framework in which the
return relationships are linear. Multivariate framework implies
that there are a variety of different factors which influence
security returns.
• The factors in the context of APT can be classified into two broad
groups, namely, macroeconomic factors having a pervasive
influence and micro (firm specific) factors. Viewed from this
perspective, the APT model (as shown ) is akin to an extended
CAPM model.
Return = R f + β j1 ( rf1 − rf ) +... + β j2 + ( rf2 − rf ) +...β jk (r jk − rf )

Where K = Number of factors that affect an asset (security) return

rf1, rf2 ,... rjk = Expected returns to factors 1,2, …K
β j1, β j2 , …β jk = Sensitivit ies of an asset (security) to factors 1,2, …K.
 Assumptions of APT Model
 Assumptions on investors preference and investors
behavior and about the world
3 assumptions needed for APT
 Investors seek return tempered by risk
Investors can borrow and lend at the risk free rate
There is no market frictions such as transaction costs ,
taxes, or restrictions on short selling.
• Investors agree on the number and identity of the
factors that are important systematically in pricing
assets.
• There are no riskless arbitrage profit opportunities
Steps involved in calculating
expected return

• Find the factors that affect the asset

return

• Estimation of risk premium for each

of the factors

• Estimation of beta for each factor

 Difference between CAPM
and APT model

• APT can be seen as a "supply-side"

model

• CAPM is considered a "demand side"

model
 PORTFOLI0 MANAGEMENT

Portfolio management is the process of defining

portfolios, evaluating, tracking and studying portfolio
performance, and reporting results to stakeholders.

Portfolio management involves the balancing of risks

and rewards for getting greater returns.
 Modern Portfolio Theory

Modern Portfolio Theory (MPT) is

based on a simple assumption that
risk is defined by volatility.

According to the theory, investors

are risk adverse: they are willing to
accept more risk (volatility) for
higher payoffs and will accept lower
returns for a less volatile investment.
• The core principle of portfolio management theory is diversification

• Theory of portfolio diversification was advocated by Sir Harry

Markowitz in 1950`s

• He made an attempt to quantify the risk of a portfolio and develop

a methodology for determining the optimum portfolio.
 Assumptions

The mathematical framework of MPT makes many

assumptions about investors and markets.

All investors are rational and risk-averse. This

is another assumption of the efficient market
hypothesis, but we now know from behavioural
economics that market participants are not rational.
It does not allow for "herd behaviour" or investors
who will accept lower returns for higher risk. 
• All investors have access to the
same information at the same
time. 

This also comes from the efficient

market hypothesis. In fact, real
markets contain information
asymmetry, insider trading, and
those who are simply better
informed than others.
Correlations between assets are fixed and
constant forever. 

Correlations depend on systemic relationships

between the underlying assets, and change when
these relationships change.

Examples include one country declaring war on

another, or a general market crash.

During times of financial crisis all assets tend to

become positively correlated, because they all move
(down) together.
• Here are no taxes or transaction costs. Real
financial products are subject both to taxes and
transaction costs (such as broker fees), and taking
these into account will alter the composition of the
optimum portfolio. These assumptions can be
relaxed with more complicated versions of the
model.

• Any investor can lend and borrow an unlimited

amount at the risk free rate of interest. In reality,
every investor has a credit limit.
 Diversification and portfolio risk

• Impact of diversification on risk

• An investor can reduce portfolio risk simply by holding

combinations of instruments which are not perfectly
positively correlated (correlation coefficient .

• In other words, investors can reduce their exposure to individual

asset risk by holding a diversified portfolio of assets.

• Diversification may allow for the same portfolio expected return

with reduced risk.
 Example

• Mr. X wants to invest an amount of

Rs1,00,000 in stocks. He has two
options in this regard stock A and
stock B. according to assessments it
is shown that the probability
distributions of the returns of both the
stocks are same. five economies have
been taken into consideration
,assuming the economies to be
equiprobable.
 Probability Distribution of Returns

State of the Probability Return on Return on Return on

economy stock A stock B portfolio

1 0.20 15% -5% 5%

2 0.20 -5% 15% 5%

3 0.20 5% 25% 15%

4 0.20 35% 5% 20%

5 0.20 25% 35% 30%

 Expected return on stock A , B as well
as the portfolio is 15%

 But the standard deviation for stock A

is 14.14% , for stock B is 14.14% and
for the portfolio is 9.49%

 Thus in this case we see that

diversification reduces risk.
Relationship between diversification and
risk
• Systematic risk/market risk / non –diversifiable risk . It
applies to all the securities and portfolio of securities
across all sectors due to factors such as growth rate of
GNP ,level of government spending, etc

• An investor can’t reduce the systematic risk of his portfolio

by investing in multiple sectors or securities.

• Unsystematic risk /unique risk of a security represents

that portions of a portfolio which stems from firm specific
factors It does not affect the other firms in general
As we can see from the figure that as the number of
securities are increased in a portfolio the systematic
risk remains constant while the unsystematic risk
reduces and then becomes stagnant.

As a result the total risk also decreases initially and

then it reaches a minimum point very close to the
systematic risk.

One important point to note here is that investors are

not rewarded for assuming unsystematic risk
because it can be eliminated through diversification.

Thus investors are rewarded for assuming only

systematic risk.
 Portfolio return and risk

• Most investors do not hold stocks in

isolation. Instead, they choose to hold a
portfolio of several stocks.

• This diversify the risk of an individual

stock's.
 Portfolio Expected Return

• The Expected Return on a Portfolio is

computed as the weighted average of
the expected returns on the excepted
returns on the individual securities in the
portfolio.

• E[Rp] = the expected return on the portfolio,

• wi = the proportion of the portfolio invested in
stock i, and
• E[Ri] = the expected return on stock i.
 Example
Securities Excepted return Proportions

A 12% 0.20

B 15% 0.30

C 18% 0.30

D 20% 0.20

E(Rp)= 0.20 (12%) + 0.30(15%) + 0.30 (18%) + 0.20 (20%) = 16.3%

 Measurement of comovements in
security returns

• Comovements between the returns of securities are

measured by covariance & coefficient of correlation.
• Covariance: covariance reflects the degree to
which the returns of the two securities vary or
change together.

A positive covariance means that the return of the

two securities move in the same direction whereas
a negative covariance implies that the returns of the
two securities move in opposite direction.
 Example
The returns on securities 1 & 2 under five possible
states of State
nature are given
of Probabili below
Return on : Return on
Nature ty security 1 security 2
1 0.1 -10% 5%
2 0.3 15% 12%
3 0.3 18% 19%
4 0.2 22% 15%
5 0.1 27% 12%

The excepted return on security 1 is:

E(R1)=0.10 (-10%) +0.30 (15%)+030(18%)+0.20(22%)+0.10(27%) = 16%

The excepted return on security 2 is:

E(R2)=0.10 (5%) +0.30 (12%)+030(19%)+0.20(15%)+0.10(12%) = 14%

State of Probabilit Return Deviation of return Retur Deviation of Product of
nature y (2) on on security 1 from n on return on security deviations
(1) securit its mean (4) securi 2 from its mean times
y 1 (3) ty 2 (6) probability
(5) (2)x (4)x(6)

1 0.10 10% -26% 5% -9% 23.40

2 0.30 15% -1% 12% -2% 0.60

3 0.30 18% 2% 19% 5% 3.00

4 0.20 22% 6% 15% 1% 1.20

5 0.10 27% 11% 12% -2% -2.20

SUM = 26.0

Thus the covariance between the returns on the two securities is 26.0
• Coefficient of correlation: covariance
& correlation are conceptually analogous
in the sense that both of them reflect
the degree of co movement between
two variables.

• Thus the correlation coefficient is simply

covariance divided by the product of
standard deviation
 Calculation of portfolio risk
• Portfolio risk:
 Example

• A portfolio consists of two securities 1 & 2 in the

proportions 0.6 & 0.4. The standard deviations of the
returns on securities 1 & 2 are 10 & 16. The coefficient of
correlation between the returns on securities 1 & 2 is 0.5.
What is the standard deviation of the portfolio return?

={0.62 X 102+0.42 X 162+ 2X 0.6 X 0.4 X 0.5 X 10 X 16}1/2

10.7 %
 Efficient frontier
Markowitz’s model assumes that investors will only take on increased
•
risk if they will be compensated by higher-than-expected returns.

The exact trade-off will differ for each investor based on individual
•
risk aversion.

When every asset is plotted in the risk-return space, the hyperbola

•
that forms along the upper edge of this region is known as the
efficient frontier and represents the optimal combination of risk and
return.

Any combination along this efficient frontier represents a position

•
with the lowest risk for the given return. 
 Efficient Frontier

Efficient frontier for two security case:

Suppose an investor is evaluating two securities A & B.

Security A Security
B
Excepted Return 12% 20%
Standard Deviation of 20% 40%
return
coefficient of correlation -0.20
 The investor can combine securities A & B in a portfolio in a number of
ways by simply changing the proportions of funds allocated to them.

PortfolioProportion Proportion Expected Standard

of A of B Return Deviation
1 (A) 1.00 0.00 12% 20.00%
2 0.90 0.1 12.80% 17.64%
3 0.76 0.24 13.93% 16.27%
4 0.50 0.50 16.00% 20.49%
5 0.25 0.75 18.00% 29.41%
6 (B) 0.00 1.00 20.00% 40.00%
Portfolio options
 \

optimal portfolio

Also known as an efficient portfolio, an optimal

portfolio is a collection of assets that are
adequately helping an investor to reach his or
her financial goals. A portfolio of this type is
configured to include assets that the investor
feels comfortable with, and that carry a level of
risk that fits in well with the overall investment
strategy that the investor employs. Determining
whether or not a portfolio is efficient or optimal is
somewhat subjective, since what is a good fit for
one investor may or many not serve the needs of a
different investor with equal ability.
 Risk-return indifference curves

• The method used in selecting the most desirable

portfolio involves the use of indifference curves.

• These curves represent an investor's preferences

for risk and return. It can be drawn on a two-
dimensional graph, where the horizontal axis usually
indicates risk as measured by variance or standard
deviation and the vertical axis indicates reward as
measured by expected return.

• Using variance as relevant risk measure comes from

Markowitz's paper and is always used in practice,
although other possibilities have been considered
Risk return indifference curves
Utility indiffernce curves
 Optimal portfolio
• It is found at the point of
tangency between the efficient
frontier and a utility indifference
curve

• It represents the highest level of

utility that any investor can reach
Optimal portfolio
 Criticism
Assumes that deviations both above and below the level of
expected return are equally undesirable.

Assumes that the only investment objectives are the

acquisition of return and the avoidance of risk.

Assumes that historical returns will be repeated in the future.

• Markowitz’ overweight securities with high expected return
and negative correlation and underweight those with low
expected returns and positive correlation.
 Methodologies
• Comparable multiples
– P/E multiple
– Market to Book multiple
– Price to Revenue multiple
– Enterprise value to EBIT multiple
• Discounted Cash Flow (DCF)
– NPV, IRR, or EVA based Methods
• WACC method
• APV method
• CF to Equity method

©2001 M. P. Narayanan University of Michigan 106

 Valuation: P/E multiple
• If valuation is being done for an IPO or a takeover,
– Value of firm = Average Transaction P/E multiple × EPS of firm
– Average Transaction multiple is the average multiple of recent
transactions (IPO or takeover as the case may be)
• If valuation is being done to estimate firm value
– Value of firm = Average P/E multiple in industry × EPS of firm
• This method can be used when
– firms in the industry are profitable (have positive earnings)
– firms in the industry have similar growth (more likely for “mature”
industries)
– firms in the industry have similar capital structure

©2001 M. P. Narayanan University of Michigan 107

 Valuation: Price to book
multiple
• The application of this method is similar to that of the
P/E multiple method.
• Since the book value of equity is essentially the
amount of equity capital invested in the firm, this
method measures the market value of each dollar of
equity invested.
• This method can be used for
– companies in the manufacturing sector which have
significant capital requirements.
– companies which are not in technical default
(negative book value of equity)

©2001 M. P. Narayanan University of Michigan 108

 Valuation: Value to EBITDA
multiple
• This multiple measures the enterprise value, that is the
value of the business operations (as opposed to the value
of the equity).
• In calculating enterprise value, only the operational value
of the business is included.
• Value from investment activities, such as investment in
treasury bills or bonds, or investment in stocks of other
companies, is excluded.
• The following economic value balance sheet clarifies the
notion of enterprise value.

©2001 M. P. Narayanan University of Michigan 109

 Enterprise Value

Economic Value Balance Sheet

PV of future cash from business
$1500
operations

Cash $200 Debt $650

Marketable securities $150 Equity $1200

$1850 $1850

Enterprise Value

©2001 M. P. Narayanan University of Michigan 110

 Value to EBITDA multiple:
Example
• Suppose you wish to value a target company using the following
data:
– Enterprise Value to EBITDA (business operations only) multiple of
5 recent transactions in this industry: 10.1, 9.8, 9.2, 10.5, 10.3.
– Recent EBITDA of target company = $20 million
– Cash in hand of target company = $5 million
– Marketable securities held by target company = $45 million
– Interest rate received on marketable securities = 6%.
– Sum of long-term and short-term debt held by target = $75
million

©2001 M. P. Narayanan University of Michigan 111

 Value to EBITDA multiple:
Example
• Average (Value/ EBITDA) of recent transactions
– (10.1+9.8+9.2+10.5+10.3)/5 = 9.98
• Interest income from marketable securities
– 0.06 × 45 = $2.7 million
• EBITDA – Interest income from marketable securities
– 20 – 2.7 = $17.3 million
• Estimated enterprise value of the target
– 9.98 × 17.3 = $172.65 million
• Add cash plus marketable securities
– 172.65 + 5 + 45 = $222.65 million
• Subtract debt to find equity value: 222.65 – 75 = $147.65
million.

©2001 M. P. Narayanan University of Michigan 112

 Valuation: Value to EBITDA
multiple
• Since this method measures enterprise value it
accounts for different
– capital structures
– cash and security holdings
• By evaluating cash flows prior to discretionary capital
investments, this method provides a better estimate
of value.
• Appropriate for valuing companies with large debt
burden: while earnings might be negative, EBIT is
likely to be positive.
• Gives a measure of cash flows that can be used to
support debt payments in leveraged companies.

©2001 M. P. Narayanan University of Michigan 113

 Heuristic methods:
drawbacks
• While heuristic methods are simple, all of them
share several common disadvantages:
– they do not accurately reflect the synergies that may
be generated in a takeover.
– they assume that the market valuations are accurate.
For example, in an overvalued market, we might
overvalue the firm under consideration.
– They assume that the firm being valued is similar to
the median or average firm in the industry.
– They require that firms use uniform accounting
practices.

©2001 M. P. Narayanan University of Michigan 114

 Valuation: DCF method
• Here we follow the discounted cash
flow (DCF) technique we used in
capital budgeting:
– Estimate expected cash flows
considering the synergy in a takeover
– Discount it at the appropriate cost of
capital

©2001 M. P. Narayanan University of Michigan 115

 DCF methods: Starting data
• Free Cash Flow (FCF) of the firm
• Cost of debt of firm
• Cost of equity of firm
• Target debt ratio (debt to total value)
of the firm.

©2001 M. P. Narayanan University of Michigan 116

Template for Free Cash Flow
Working capital

Year 0 1 2
Revenue
“Income Statement”

Costs
Depreciation of equipment Noncash item
Profit/Loss from asset sales Noncash item
Taxable income
Tax
Net oper proft after tax (NOPAT)
Depreciation Adjustment for
Profit/Loss from asset sales for non-cash
Operating cash flow
Change in working capital
Capital Expenditure Capital items
Salvage of assets
Free cash flow

©2001 M. P. Narayanan University of Michigan 117

Template for Free Cash Flow
• The goal of the template is to estimate cash flows, not profits.
• Template is made up of three parts.

– An “Income Statement”
– Adjustments for non-cash items included in the
“Income statement” to calculate taxes
– Adjustments for Capital items, such as capital
expenditures, working capital, salvage, etc.
• The “Income Statement” portion differs from the usual income statement
because it ignores interest. This is because, interest, the cost of debt, is
included in the cost of capital and including it in the cash flow would be
double counting.
• Sign convention: Inflows are positive, outflows are negative. Items are
entered with the appropriate sign to avoid confusion.

©2001 M. P. Narayanan University of Michigan 118

Template for Free Cash Flow
• There are four categories of items in our “Income
Statement”. While the first three items occur most of the
time, the last one is likely to be less frequent.
– Revenue items
– Cost items
– Depreciation items
– Profit from asset sales
• Adjustments for non-cash items is to simply add all non-cash
items subtracted earlier (e.g. depreciation) and subtract all
non-cash items added earlier (e.g. gain from salvage).
• There are two type of capital items
– Fixed capital (also called Capital Expenditure (Cap-Ex), or
Property, Plant, and Equipment (PP&E))
– Working capital

©2001 M. P. Narayanan University of Michigan 119

Template for Free Cash Flow
• It is important to recover both at the end of a finite-lived
project.
– Salvage the market value property plant and equipment
– Recover the working capital left in the project (assume full
recovery)

©2001 M. P. Narayanan University of Michigan 120

Template for Free Cash Flow

Taxab le income = Revenue - Costs - Depreciation + Profit from asset sales

NOPAT = Taxab le income - Tax
Operating cash flow = NOPAT + Depreciation - Profit from asset sales
Free cash flow = Operating cash flow - Change in working capital - Capital Expenditure +
Salvage of equipment - Opportunity cost of land + Salvage of land
Adjustment of noncash items:
Add the noncash items you sub tracted earlier and sub tract the noncash items you added earlier.

©2001 M. P. Narayanan University of Michigan 121

 Estimating Horizon
• For a finite stream, it is usually either the life of the product or
the life of the equipment used to manufacture it.
• Since a company is assumed to have infinite life:
– Estimate FCF on a yearly basis for about 5 − 10 years.
– After that, calculate a “Terminal Value”, which is the ongoing
value of the firm.
• Terminal value is calculated one of two ways:
– Estimate a long-term growth and use the constant growth
perpetuity model.
– Use a Enterprise value to EBIT multiple, or some such multiple

©2001 M. P. Narayanan University of Michigan 122

 Costs of debt and equity
• Cost of debt can be approximated by the yield to
maturity of the debt.
• If it is not directly available, check the bond rating of
the company and find the YTM of similar rated bonds.
• Cost of equity
– CAPM
• Find β e and calculate required re.
– Use Gordon-growth model and find expected re.
Under the assumption that market is efficient, this is
the required re.

©2001 M. P. Narayanan University of Michigan 123

 Model of a Firm

Value from Value from

Operations investments
Enterprise value Value generated Equal if debt
is fairly priced

FIRM
Value to Equity

DEBT and
other EQUITY
liabilities
©2001 M. P. Narayanan University of Michigan 124
 Value of equity
• Value of equity
= Enterprise value
+ Value of cash and investments
- Value of debt and other liabilities

©2001 M. P. Narayanan University of Michigan 125

 Infrastructural Facilities
Monsoons
• Agriculture is • Necessary for growth of
directly/indirectly industrial & agricultural
linked to monsoons. sectors.
• Adequate/regular supply of
• Certain industries electric power.
depend on agriculture • Well developed
for raw material. transportation &
communication system.
• Good monsoon • Continuous supply of basic
bumper crop industrial raw materials
buoyancy in stock (steel, coal, petroleum
prdts & cement).
market.
• Financial sectors.
• Monsoons are bad
agriculture & other
production suffer -ve
effect on share market
 Interest Rate Debt Recovery & Loans
• Affects the cost of Outstanding
financing to the
No so good recovery of
firms.
debts bad debts  higher NPA 
↓interest rate 
erosion of profit  banks collapse 
lower cost of finance more risk  less return.
for firm
more money No employment  no disposable
available @ low income  no demand for prdts
interest rates  GDP falls  Don’t save 
encourages firms to don’t invest 
do better stock prices falls 
business  return reduces 
profitability  risk increases.
↑price of shares.
• MONEY SUPPLY:
An increase in money supply would lead
to inflation, and may increase discount rate
and reduce stock prices.
The negative effects might be countered by
the economic stimulus provided by money
growth, also known as the corporate earnings
effect, which may increase future cash flows
and stock prices.

• GROWTH IN GDP:
the growth rate of economy points out the
prospects for the industrial sector & the return
investor can expect from investment in shares.
The higher the growth rate is more favourable to
the stock market.
• INFLATION:
mild level of inflation is good to the stock
market, but high rate of inflation is harmful
to the stock market.

• COST OF LIVING:
less no savings no capital
formation
less investment no growth
STAGE OF THE BUSINESS CYCLE:
Stage 1: Slowing growth rates or early recession.

Stage 2: Business cycle trough.

Stage 3: Late recession and early recovery.
Stage 4: Early recovery.
Stage 5: Cycle peak.
Stage 6: Slowing growth.
• Technical involvement:
The technical involves a study of market generated data like price and
volumes to determine the future direction of price movement. The
technical approach to investing is essentially a reflection of the idea that
price move in trends which are determined by the changing attitude of
investors towards a verity of economic monetary political and
psychological force.

• Foreign Investment:
Foreign investment in India norms in two forms foreign direct
investment and foreign portfolio investment. The former represents
investment for setting up new projects and hence is long term nature the
later is in the form of purchase of outstanding securities in the capital
market and hence can be reserved easily
• Stock Price:
Stock price determine showing how economic variable interact to
determine stock price. The value of a call option other things being
constant increase with the stock price. This point is obvious and its
relationship between the stock price and the value of call money.

• Industrial wages :
The reduction of wages would diminish the income of the community
and the demand for goods at a given level of price. So that the volume of
goods sold at lover price would not be a greater. There would then be no
reason to increase production and employment.
• Strategy of Politics and Economic stability:
Political events and processes within the host country, changing relationships
between the host and the home country, as well as between the host country and
third countries, will influence the economic well-being of the parent firm .
Political risk can be classified as macro political risk and micro political risk .

Economic booms and busts have always been a part of human history. A
general tendency in economics is that innovation leads to increased economic
activity which then can result in economic booms and then economic busts. The
improvement in production, transportation or information technology leads new
financial instruments.
 INDUSTRIAL PRODUCTION
• An economic indicator that is released monthly by the Federal Reserve Board. The
indicator measures the amount of output from the manufacturing, mining, electric and
gas industries.
• Production data is often received directly from the Bureau of Labor Statistics and trade
associations, both on physical output and inputs used in the production process. Each
individual index is calculated using the Fischer index formula.
• Investors can use the IPI of various industries to examine the growth in the respective
industry. If the IPI is growing month-over-month for a particular industry, this is a sign
that the companies in the industry are performing well.

CAPACITY UTILISATION
• Capacity utilization is a concept in economics which refers to the extent to which an
enterprise or a nation actually uses its installed productive capacity. Thus, it refers to
the relationship between actual output that 'is' produced with the installed equipment
and the potential output which 'could' be produced with it, if capacity was fully used.
CAPACITY UTILISATION (CONTI…)
• A metric used to measure the rate at which potential output levels are being met
or used. Displayed as a percentage, capacity utilization levels give insight into
the overall slack that is in the economy or a firm at a given point in time. If a
company is running at a 70% capacity utilization rate, it has room to increase
production up to a 100% utilization rate without incurring the expensive costs
of building a new plant or facility. Also known as "operating rate“ This is best
applied to companies that produce physical goods rather than services, as the
capacity measurements are much easier to quantify.

FOREIGN EXCHANGE RATES

• An economic indicator or business indicator is recorded data that gives
insights into the stance of the economy as a whole .Economic indicators
are recorded and used for the analysis of the current economic situation
and also for the prediction of future economic changes. Forex indicators
are used to analyze Forex performance and play a major role in future
Forex forecasts and future Forex performances. Forex traders use forex
indicators to dictate major entry and exit points.
ECONOMIC AND INDUSTRIAL POLICES OF THE GOVERNMENT
• ECONOMIC POLICY: Economic policy refers to the actions that governments take in the
economic field. It covers the systems for setting interest rates and government budget as well as
the labour market, national ownership, and many other areas of government interventions into the
economy. Such policies are often influenced by international institutions like the International
Monetary Fund or World Bank as well as political beliefs and the consequent policies of parties.
• INDUSTRIAL POLICY: Industrial policy means rules, regulations, principles, policies and
procedures laid down by government for regulating, developing and controlling industrial
undertaking in the country. It prescribes the respective roles of the public, private, joint and co-
operative sectors for the development of industries. It also indicates the role of the large, medium
and small scale sector. It incorporates fiscal and monetary policies, tariff policy, labour policy and
the government attitude towards foreign capital.

PRODUCTIVITY OF FACTORS OF PRODUCTION

• In economics, factors of production (or productive inputs or resources) are any commodities or
services used to produce goods and services. 'Factors of production' may also refer specifically to
the primary factors, which are stocks including land, labour (the ability to work), and capital
goods applied to production. The primary factors facilitate production but neither become part of
the product (as with raw materials) nor become significantly transformed by the production
process (as with fuel used to power machinery).