Risk and Return

Determinants of Intrinsic Value:

The Cost of Equity

Net operating Required investments

profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF

Value = + + ...+
(1 + WACC)1 (1 + WACC) 2
(1 + WACC)

Weighted average
cost of capital
(WACC)

Market interest rates Cost

Cost of
of debt
debt Firms debt/equity mix

Market risk aversion Cost

Cost of
of equity
equity Firms business risk
Important Notes

1. Risk of financial asset is judged by the risk of

its cash flow
2. Asset risk: Stand Alone basis vs. Portfolio
Context
3. Portfolio context: Diversifiable Risk vs. Market
Risk.
4. Investors in general are Risk Averse
STAND ALONE RISK
Stand alone risk: the risk an
investor would face if she or he held
only one particular asset.

Investment risk pertains to the

probability of actually earning a low
or negative return. The greater the
chance of low or negative returns,
the riskier the investment.
Probability Distribution &
Expected Rate of Return

Dollar Return
rate of return =
Amount invested
Amount received - Amount invested
=
Amount invested

^
r = expected rate of return.
n
r = Pi ri .
i =1
Probability Distribution &
Expected Rate of Return
Probability distribution
Continuous Probability Distribution
Stand Alone Risk: Measurements

Standard Deviation: a measure of the tightness of

the probability distribution. The tighter the probability
distribution, the smaller the Standard Deviation and
the less risky the asset.

Coefficient of Variation: Standard Deviation divided

by return. It measures risk per unit of return, thus
provides more standardized basis for risk profile
comparison between assets with different return.
Standard Deviation

Variance The larger the Standard

n Deviation:
2
= i
(r - r)
2
Pi the lower the probability
that actual returns will be
i =1 close to the expected
return
hence the larger the risk

Standard Deviation
n
= i =1
(ri - r) 2 Pi
Standard Deviation
Historical Data to Measure
Standard Deviation

Standard Deviation

( r t - r Avg ) 2
Estimated = S = t =1

n 1
Historical Data to Measure
Standard Deviation
Coefficient of Variation (CV)

Standardized measure of dispersion

about the expected value:

CV = ^
r

Shows risk per unit of return.

 A B

A = B , but A is riskier because larger

probability of losses.

^ = CVA > CVB.

r
Risk & Return
in Portfolio Context
Return
^
rp is a weighted average:
n
rp = wiri.
^ ^

i=1

Risk
Correlation Coefficient to measure the tendency
of two variables moving together
Portfolio Return
Stock Portfolio weight Expected Return
Microsoft 0,25 12,0%
General Electric 0,25 11,5%
Pfizer 0,25 10,0%
Coca-Cola 0,25 9,5%

Portfolio's Expected Return 10,75%

Portfolio Risk:
Standard Deviation of 2-Asset-Portfolio
Variance

p
2
= w1 1 + w2 2 + 2( w1 w2 1 2 12 )
2 2 2 2

Covariance
Cov12 = 12 = 1 2 12

Correlation Coeficient = 12

Standard Deviation

p = p
2
 Portfolio Risk:
Standard Deviation of 2-Asset-Portfolio

The standard deviation of a portfolio is generally not a

weighted average of individual standard deviations (SD).

The portfolio's SD is a weighted average only if all the

securities in it are perfectly positively correlated. Risk is not
reduced at all if the two stocks have r = +1.0.

Where the stocks in a portfolio are perfectly negatively

correlated, we can create a portfolio with absolutely no risk,
or Portfolios SD equal to 0. Two stocks can be combined
to form a riskless portfolio if r = -1.0.
Portfolio Risk:
Perfectly Negative Correlation

Portfolio WM
Year Stock W returns Stock M returns (Equally weighted avg.)
2000 40% -10% 15%
2001 -10% 40% 15%
2002 35% -5% 15%
2003 -5% 35% 15%
2004 15% 15% 15%
Average return 15% 15% 15%
Standard deviation 25.00% 25.00% 0.00%
Correlation Coefficient -1.00
Returns Distribution for Two Perfectly
Negatively Correlated Stocks ( = -1.0) and
for Portfolio WM

Stock W Stock M Portfolio WM

40 . 40
. . 40

15 . 15 . 15 . . . . .
0 0 0
. .
-10
. -10
. -10
Portfolio Risk:
Perfectly Positive Correlation

Year Stock M returns Stock M' returns Portfolio MM'

2000 -10% -10% -10%
2001 40% 40% 40%
2002 -5% -5% -5%
2003 35% 35% 35%
2004 15% 15% 15%
Average return 15% 15% 15%
Standard deviation 22,64% 22,64% 22,64%
Correlation Coefficient 1,00
 Returns Distributions for Two Perfectly
Positively Correlated Stocks (= +1.0) and
for Portfolio MM

Stock M Stock M Portfolio MM

40 40 40

15 15 15

0 0 0

-10 -10 -10

Portfolio Risk:
Partial Correlation
Adding Stocks to a Portfolio
What would happen to the risk of an average
1-stock portfolio as more randomly selected
stocks were added?
p would decrease because the added stocks
would not be perfectly correlated

25
Effects of Portfolio Size on
Portfolio Risk
Market risk is that part of a securitys
stand-alone risk that cannot be eliminated
by diversification, and is measured by
beta.
Firm-specific risk is that part of a securitys
stand-alone risk that can be eliminated by
proper diversification.
Capital Asset Pricing Model &
The Concept of Beta
Market risk, which is relevant for stocks held in well-diversified
portfolios, is defined as the contribution of a security to the overall
riskiness of the portfolio. It is measured by a stocks beta coefficient.
Beta measures a stocks market risk. It shows a stocks volatility
relative to the market.
Beta shows how risky a stock is if the stock is held in a well-diversified
portfolio.
Beta can be calculated by running a regression of past returns on Stock
i versus returns on the market. The slope of the regression line is
defined as the beta coefficient.
If beta > 1.0, stock is riskier than the market.
If beta < 1.0, stock less risky than the market.

i
bi =
i,M

M
Using a Regression to
Estimate Beta
Run a regression with returns on the stock in
question plotted on the Y axis and returns on
the market portfolio plotted on the X axis.
The slope of the regression line, which
measures relative volatility, is defined as the
stocks beta coefficient, or b.

29
Beta - Illustration
Calculating Beta in Practice
Many analysts use the S&P 500 to find the
market return.
Analysts typically use four or five years of
monthly returns to establish the regression
line.
Some analysts use 52 weeks of weekly
returns.

31
Beta - Calculation
CALCULATING THE BETA COEFFICIENT FOR AN ACTUAL COMPANY
Now we show how to calculate beta for an actual company, General Electric.

Step 1. Acquire Data

Step 2. Calculate Returns

Market Level GE Adjusted Stock

Date (S&P 500 Index) Market Return Price GE Return
Maret 2003 848,18 0,8% 25,50 6,0%
Februari 2003 841,15 -1,7% 24,05 4,7%
Maret 1999 1.286,37 NA 34,42 NA

Average return
(annual) -8,8% -3,4%
Standard deviation
(annual) 17,6% 29,2%
Correlation between GE and the market. 66,0%
Beta (using the SLOPE function) 1,09
How is beta interpreted?
If b = 1.0, stock has average risk.
If b > 1.0, stock is riskier than average.
If b < 1.0, stock is less risky than average.
Most stocks have betas in the range of 0.5 to
1.5.

33
Security Market Line (SML)
Relationship between required rate of return and risk

ri = rRF + RPMbi .

ri = rRF + (rM rRF)bi .

ri = Required return ^on Stock i

rRF = Risk-free return
(rM-rRF) = Market risk premium
bi = Beta of Stock i