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, he takes on
fundamental risk – the stock price could drop because the firm’s operations
don’t meet expectations – but he also runs the (price) risk of buying a stock
that is overpriced or selling a stock that is underpriced. Chapter 18
elaborates and Figure 18.5 (in Chapter 18) 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 aver ages when risky
investment is involved. Those averages from the past are not guaranteed in
the future. Stocks are more risky than bonds – they can yield much lower
returns than past averages. The investor who holds stocks (for retirement,
for example) may well find that her stocks have fallen when she comes to
liquidate them. 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 and a lost considerable amount of their retirement “nest
egg.”
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.
, 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
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, he takes on
fundamental risk – the stock price could drop because the firm’s operations
don’t meet expectations – but he also runs the (price) risk of buying a stock
that is overpriced or selling a stock that is underpriced. Chapter 18
elaborates and Figure 18.5 (in Chapter 18) 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 aver ages when risky
investment is involved. Those averages from the past are not guaranteed in
the future. Stocks are more risky than bonds – they can yield much lower
returns than past averages. The investor who holds stocks (for retirement,
for example) may well find that her stocks have fallen when she comes to
liquidate them. 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 and a lost considerable amount of their retirement “nest
egg.”
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.
, 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
