CHAPTER ONE
Introduction to Investing and Valuation
Concept Questions
C1.1. Fundamental risk arises from the inherent risk in the business – from
sales revenue falling or expenses rising unexpectedly, for example. Price risk
is the risk of prices deviating from fundamental value. Prices are subject to
fundamental risk, but can move away from fundamental value, irrespective of
outcomes in the fundamentals. When an investor buys a stock, she takes on
fundamental risk – the stock price could drop because the firm’s operations
don’t meet expectations – but she also runs the (price) risk of buying a stock
that is overpriced or selling a stock that is underpriced. Chapter 19 elaborates
and Figure 19.5 (in Chapter 19) gives a display.
C1.2. A beta technology measures the risk of an investment and the required
return that the risk requires. The capital asset pricing model (CAPM) is a beta
technology; is measures risk (beta) and the required return for the beta. An
alpha technology involves techniques that identify mispriced stocks than can
earn a return in excess of the required return (an alpha return). See Box 1.1.
The appendix to Chapter 3 elaborates on beta technologies.
C1.3. This statement is based on a statistical average from the historical
data: The return on stocks in the U.S. and many other countries during the
twentieth century was higher than that for bonds, even though there were
periods when bonds performed better than stocks. So, the argument goes, if
one holds stocks long enough, one earns the higher return. However, it is
dangerous making predictions from historical averages when risky investment
is involved. Averages from the past are not guaranteed in the future. After all,
the equity premium is a reward for risk, and risk means that the investor can
get hit (with no guarantee of always getting a higher return). The investor who
holds stocks (for retirement, for example) may well find that her stocks have
fallen when she comes to liquidate them. Indeed, for the past 5-year period,
the past 10-year period, and the past 25-year period up to 2010, bonds
outperformed stocks—not very pleasant for the post war baby-boomer at
Introduction to Investing and Valuation
Concept Questions
C1.1. Fundamental risk arises from the inherent risk in the business – from
sales revenue falling or expenses rising unexpectedly, for example. Price risk
is the risk of prices deviating from fundamental value. Prices are subject to
fundamental risk, but can move away from fundamental value, irrespective of
outcomes in the fundamentals. When an investor buys a stock, she takes on
fundamental risk – the stock price could drop because the firm’s operations
don’t meet expectations – but she also runs the (price) risk of buying a stock
that is overpriced or selling a stock that is underpriced. Chapter 19 elaborates
and Figure 19.5 (in Chapter 19) gives a display.
C1.2. A beta technology measures the risk of an investment and the required
return that the risk requires. The capital asset pricing model (CAPM) is a beta
technology; is measures risk (beta) and the required return for the beta. An
alpha technology involves techniques that identify mispriced stocks than can
earn a return in excess of the required return (an alpha return). See Box 1.1.
The appendix to Chapter 3 elaborates on beta technologies.
C1.3. This statement is based on a statistical average from the historical
data: The return on stocks in the U.S. and many other countries during the
twentieth century was higher than that for bonds, even though there were
periods when bonds performed better than stocks. So, the argument goes, if
one holds stocks long enough, one earns the higher return. However, it is
dangerous making predictions from historical averages when risky investment
is involved. Averages from the past are not guaranteed in the future. After all,
the equity premium is a reward for risk, and risk means that the investor can
get hit (with no guarantee of always getting a higher return). The investor who
holds stocks (for retirement, for example) may well find that her stocks have
fallen when she comes to liquidate them. Indeed, for the past 5-year period,
the past 10-year period, and the past 25-year period up to 2010, bonds
outperformed stocks—not very pleasant for the post war baby-boomer at
