SOLUTIONS TO
EXERCISES AND CASES
For
FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION
Stephen H. Penman
Fifth Edition
1
, 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
2
,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 retirement age at that point who had held “stocks for
the long run.” Waiting for the “long-run” may take a lot of time (and “in the long run we are all
dead”).
The historical average return for equities is based on buying stocks at different times, and
averages out “buying high” and “buying low” (and selling high and selling low). An investor
who buys when prices are high (or is forced to sell when prices are low) may not receive the
typical average return. Consider investors who purchased shares during the stock market bubble
in the 1990s: They lost considerable amount of their retirement “nest egg” over the next few
years. See Box 1.1.
C1.4. A passive investor does not investigate the price at which he buys an investment. He
assumes that the investment is fairly (efficiently) priced and that he will earn the normal return
for the risk he takes on. The active investor investigates whether the investment is efficiently
priced. He looks for mispriced investments that can earn a return in excess of the normal return.
See Box 1.1.
3
, C1.5. This is not an easy question at this stage. It will be answered in full as the book proceeds.
But one way to think about it is as follows: If an investor expects to earn 10% on her investment
in a stock, then earnings/price should be 10% and price/earnings should be 10. Any return above
this would be considered “high” and any return below it “low.” So a P/E of 33 (an E/P yield of
3.03%) would be considered high and a P/E of 8 (an E/P yield of 12.5%) would be considered
low. But we would have to also consider how accounting rules measure earnings: If accounting
measures result in lower earnings (through high depreciation charges or the expensing of
research and development expenditure, for example) then a normal P/E ratio might be higher
than 10. And one also has to consider growth: If earnings are expected to be higher in the future
than current earnings, the E/P ratio should be lower than this 10% benchmark (and the
corresponding P/E higher). In early 2012, the S&P 500 P/E ratio stood at 14.4.
C1.6. The firm has to repurchase the stock at the market price, so the shareholder will get the
same price from the firm as from another investor. But one should be wary of trading with
insiders (the management) who might have more information about the firm’s prospects than
outsiders (and might make stock repurchases when they consider the stock to be underpriced).
Some argue that stock repurchases are indicative of good prospects for the firm that are not
reflected in the market price, and firms repurchase stocks to signal these prospects. Firms buy
stocks because they think the stock is cheap.
C1.7. Yes. Stocks would be efficiently priced at the agreed fundamental value and the market
price would impound all the information that investors are using. Stock prices would change as
new information arrived that revised the fundamental value. But that new information would be
4
EXERCISES AND CASES
For
FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION
Stephen H. Penman
Fifth Edition
1
, 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
2
,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 retirement age at that point who had held “stocks for
the long run.” Waiting for the “long-run” may take a lot of time (and “in the long run we are all
dead”).
The historical average return for equities is based on buying stocks at different times, and
averages out “buying high” and “buying low” (and selling high and selling low). An investor
who buys when prices are high (or is forced to sell when prices are low) may not receive the
typical average return. Consider investors who purchased shares during the stock market bubble
in the 1990s: They lost considerable amount of their retirement “nest egg” over the next few
years. See Box 1.1.
C1.4. A passive investor does not investigate the price at which he buys an investment. He
assumes that the investment is fairly (efficiently) priced and that he will earn the normal return
for the risk he takes on. The active investor investigates whether the investment is efficiently
priced. He looks for mispriced investments that can earn a return in excess of the normal return.
See Box 1.1.
3
, C1.5. This is not an easy question at this stage. It will be answered in full as the book proceeds.
But one way to think about it is as follows: If an investor expects to earn 10% on her investment
in a stock, then earnings/price should be 10% and price/earnings should be 10. Any return above
this would be considered “high” and any return below it “low.” So a P/E of 33 (an E/P yield of
3.03%) would be considered high and a P/E of 8 (an E/P yield of 12.5%) would be considered
low. But we would have to also consider how accounting rules measure earnings: If accounting
measures result in lower earnings (through high depreciation charges or the expensing of
research and development expenditure, for example) then a normal P/E ratio might be higher
than 10. And one also has to consider growth: If earnings are expected to be higher in the future
than current earnings, the E/P ratio should be lower than this 10% benchmark (and the
corresponding P/E higher). In early 2012, the S&P 500 P/E ratio stood at 14.4.
C1.6. The firm has to repurchase the stock at the market price, so the shareholder will get the
same price from the firm as from another investor. But one should be wary of trading with
insiders (the management) who might have more information about the firm’s prospects than
outsiders (and might make stock repurchases when they consider the stock to be underpriced).
Some argue that stock repurchases are indicative of good prospects for the firm that are not
reflected in the market price, and firms repurchase stocks to signal these prospects. Firms buy
stocks because they think the stock is cheap.
C1.7. Yes. Stocks would be efficiently priced at the agreed fundamental value and the market
price would impound all the information that investors are using. Stock prices would change as
new information arrived that revised the fundamental value. But that new information would be
4
