Week 4 Assignment
Week 4 opens up with Risk. How do we deal with this uncertainty called risk (Links to an external site.)Links to an external site.? Two ways are through sensitivity analysis (Links to an external site.)Links to an external site. and scenario analysis (Links to an external site.)Links to an external site.. Sensitivity Analysis (Links to an external site.)Links to an external site. uses several possible return estimates to obtain a sense of variability among outcomes. So I could input those levels of return that I could reasonably expect, and generate some estimates of my returns. The limitation here is that I am only adjusting one value at a time.
Scenario analysis (Links to an external site.)Links to an external site. takes sensitivity to the next level and looks at several variables simultaneously. It looks at several what-if? What if our cost of capital increases and our sales go down? How will that impact our NPV?
So what do all these statistics have to do with investments? We as investors are typically overseeing a portfolio of securities. A portfolio (Links to an external site.)Links to an external site. can be thought of as a collection of investments the individual has undertaken (e.g. stock purchases, bond issues, other capital investments) that provide some rate of return. Referencing my comments above, each of these capital or financial investments have some rate of return that can be measured statistically. When I combine all my investments into a single portfolio, I have a collection of securities with their individual risk and return rates. However, taken as a collection changes the individual risk into more of a group type risk. I will not repeat the calculations provided in the text, but suffice to say, they can be quite daunting. The key again, is to understand the theory behind portfolio allocation. Instead of a single risk and return, I am now looking at a mixture based on the blend in my portfolio. A low standard deviation typically means that there is lower variance in my portfolio returns – e.g. more predictable, and a higher standard deviation means that I have less predictability in my portfolio returns.
Now that we have a general understanding of portfolios (Links to an external site.)Links to an external site. and the statistics that point to risk and returns, we can consider diversification and portfolio risk. This is very similar to the saying about putting all your eggs into one basket. What does this mean to those of you outside of Iowa? It means that when we allocate our financial resources, we should not place all of our investments into a single company or industry. We need to spread out our investments across several industries in order to avoid severe downturns that could happen to a company or industry. An example here would be investing all my money in the Financial Industry early in 2007. I would have done really well for the first few months, but when the mortgage meltdown started to take effect, I would have lost a substantial portion of my portfolio.
Another important concept in portfolio allocation is beta (Links to an external site.)Links to an external site. (β). Beta (Links to an external site.)Links to an external site. is an indication of how a security performs relative to the market. The market is assigned a β of 1.00. A security assigned a β of greater than 1.00 is considered more volatile than the market and a security lower than one is considered less volatile. As an example, I was a victim of the .com craze. And I remember watching Bloomberg in 1999. As the market went up, my tech stocks really went up. My average β for my portfolio was 1.2. So every time the market went up 100 points, my portfolio went up 120 points. I also remember having my daughter on my lap while I watched Bloomberg (Links to an external site.)Links to an external site.. If the market went up 100 points, she pooped her diaper. If the market went down 100 points, she pooped her diaper. And if the market was flat for the day? You guessed it, she pooped her diaper. Fortunately, I also had stock in Kimberly & Clark (Links to an external site.)Links to an external site. – makers of diapers. Their β at the time was about .8. If the market went nuts, my portfolio went a little nuts. And if the market went down, my portfolio was not as damaged. My message in all of this (besides letting you know that I was just that far away from a sure fire way of predicting stock movement) is that portfolio Beta (Links to an external site.)Links to an external site. is used to mitigate risk in investments.
What determines β? We have got some great statistical formulas to show us how. Given that that level of statistics is outside the scope of this class, it will be sufficient to say that β is determined by the covariance of the security with market and the variance of the market. But the key in this is knowing that we are constantly comparing our portfolio with the potential behavior of the market. You would also surmise that different industries have different β. My former industry, agriculture, is very cyclical. The β of Deere is 1.22. A non-cyclical industry – maybe funeral homes for example – would have a much lower β. But lets say for example that I hold two securities, Deere (DE (Links to an external site.)Links to an external site.) and Funeral Depot (FD). The β for Deere as mentioned earlier is 1.22. The β for FD is .78, and each are in each proportion. My overall β for this portfolio would be 1.00. In other words, I am balancing my risk to be congruent with the market. For further information on portfolio risk and betas, see Portfolio Theory (Links to an external site.)Links to an external site..
There are many variables that would form a firms beta. Of course, the primary determinate is the industry to which the business belongs. As I mentioned earlier, manufacturing industries such as automobiles and farm equipment are very cyclical. Other industries such as consumer staples are much more stable. Other factors that impact the beta are their sales history, and how the firms finances (debt/equity) are structured.
Typically, project managers want to do something now. But what if I could delay, or speed up implementation based on some relevant information? An example being again, I want to set up manufacturing in China. But I want to wait until the Chinese government approves an economic stimulus package. It would behoove me to wait until I can get those tax breaks. Timing too may be an attractive option.
Now that we have bonds out of the way, how about stock. Unlike bonds which are a loan to a corporation, stock entitles the owner to have a piece of ownership in a firm. I am not loaning the company money, but I am giving the corporation my money for a stake in its future profits. That is what makes stock ownership so attractive – my profits are unlimited. With a bond, my profits are fairly limited to interest payments and payment of my principle at the end of the bonds life.
So given the above, what is a stock worth? In calculating the process of a bond, it is pretty straight forward. I discount my cash flows to todays dollars using an interest rate factor. With stock, there are more than a few theories, of which I will cover. The first one is the Basic Common Stock Valuation Model (Links to an external site.)Links to an external site..
When you own stock, what do you own? The right to future earnings. Nothing more. That addresses the first valuation model. In the basic common stock valuation model, the value of a share of stock = Present value of all cash flows (dividends) over a perpetuity. Remember, that a bond has a limited life. It is issued for a given period of time. A stock has unlimited life – it is stake in the ownership of the firm. Corporations are not started with a definite end in mind. I would not say, I am going to start a career consultation business and plan a limited life of 20 years. I would hope that it grows and at some future point, sell the business and retire to Tahiti (Links to an external site.)Links to an external site..
The next model that we will consider is the Zero Growth Model (Links to an external site.)Links to an external site.. In the zero growth model, it is thought that the dividends will not raise over time. This is equal to a perpetuity. So, if I am looking at Deere, the current dividend is $1.82. If I require a 8% rate of return, then 1.82/0.08 = 22.75. However, the stock currently trading at $126. Using this example, Deere is trading too high.
Constant Growth Model (Links to an external site.)Links to an external site. assumes that stocks will grow at a constant rate, but at a rate that is less than the required return. The formula is:
Po = D1 / ks - g
d1 = Most recent dividend
ks = Required return
g = Historical dividend rate
Finally, there is the Variable growth model (Links to an external site.)Links to an external site. which allows for a change in dividend growth rate. The formula for this model is a horribly long calculation. Just know it exists and it is another way to determine the value of a stock.
Ok, but now you may be asking what do we do if a firm pays no dividends? Amazon (Links to an external site.)Links to an external site. being an example. We would then use the Free Cash Flow Valuation Model (Links to an external site.)Links to an external site.. Again, this is a nasty calculation but know that it exists. The essence of this theory is that the value of a common share of stock is equal to the present value of all future cash flows it is expected to return forever.
Are there any easier ways? Yes. We can look at Book value per share. Let us say I sold all of a firms assets for their accounting value, and paid off all liabilities, and then divided that by the number of shares outstanding, then I would have the value of the company. In essence, this should be the share price. However, the problem with his method is that it ignores all future earnings.
I could also try to sell all of a firms assets for their market value, and pay off all liabilities, and then divide that by the number of shares outstanding, and then I would have the value of the company. This lovingly referred to Liquidation value. Again, I am ignoring the future stream of earnings.
Finally, I can consider the P/E Ratio (Links to an external site.)Links to an external site.. The P/E ratio is the price of the stock (P) divided by its earnings per share (E). Again since this is a ratio, I would do a comparative analysis over time and across the industry to assess the price of my stock. If it is out of line with the industry, it should be for a very good reason.
Preferred stock is another instrument that a firm uses to secure funds. Preferred stock is just that – there is some preferential treatment to holders of preferred stock. Preferred stock trades like a stock, but in many ways behaves like a bond. You get a fixed amount of dividends per specified period. However, preferred stock usually has an indefinite life.
I have listed the Basic Rights of Preferred stockholders (Links to an external site.)Links to an external site.. As you can see, preferred is very much like a bond and a share of stock.
· Preferred Stock is not given a voting right (implies debt).
· Preference over common stockholders when it comes to distribution of earnings.
· Preference over common stockholders when it comes to liquidation of the firm.
To wrap up this chapter, I would like to discuss the differences between debt and equity capital.
As a very short review, debt capital is all long term borrowing incurred by a firm, including bonds. Equity capital are the long term funds provided by the firms owners, the stockholders. We then continue to generate equity capital by retaining our earnings and reinvesting in the firm, or sell more common or preferred stock.
As a summary, I would like to outline the differences between stock and other forms of capital:
· As equity, stockholders have a voice in management. Stockholders have voting rights that allow them to select firms directors and other voting privileges. If you issue a bond, you have no voice in the issues of the firm.
· Shareholders are subordinate to other creditors. If the firm goes under, everyone else gets their money before a stockholder does. Therefore, I need to be compensated higher for my risk.
Stock has no maturity (Old joke – what do stock and men have in common? – they both do not achieve maturity). As equity, stock is a permanent form of financing.
Like I wrote last week, in your potential future work as business or financial managers, you may be involved with selecting business opportunities for your company. How do you know that one opportunity is better than another? We could run the financial analyses to make some judgment. We are starting to know what questions to ask and what types of answers would be acceptable. We can also start to analyze the data and make a determination if this is the best option for our firm. And not only can we run the financials, but also consider options outside of IRR and NPV.
I would like to discuss your first assignment for this class, your Identifying and Managing Risk paper. OK, here are the specifications:
Name of Assignment: Identifying and Managing Risk
Assignment Instructions:
In this assignment you will compare and evaluate risk management techniques from experts in the field.
Go to the Ashford Library and find one article by James Kallman. Dr. Kallman, an expert in the field of risk management, has written many articles on managing financial risk. Find a second article in the Ashford Library from another credible author of your choice who also provides recommendations for risk management.
Develop a three to four page analysis, excluding title and reference page(s), of the techniques Dr. Kallman has identified for managing risks. In this analysis, compare Dr. Kallmans techniques to the techniques recommended in the second article you researched. Explain why you either agree or disagree with each authors recommendations. Identify other factors you believe should be considered in risk management. The assignment should be comprehensive and include specific examples. The paper should be formatted according to APA.
This is a lot like your Week 1 assignment. You will go back to the library and find two articles – one by Dr. Kallman, and another by an author knowledgeable on risk mitigation.
You will start off by summarizing Dr. Kallmans article (appx. 3/4 page). I expect that you will paraphrase and not use large direct quotes.
The second ¾ page will be a summarization from another author. Again, paraphrase and do not use large direct quotes.
The second to third pages will be a compare and contrast. What is similar between the two? Anything different? I expect a well thought out third page – not just a single paragraph.
Again, be sure to cite and quote correctly using APA guidelines.