Page 269 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes
The leading analyst expects the stock to go up by 12% this year as the company has
finished expanding its capacity six months before time. He also expects the stock to gain
28% in the next two years.
Mr. Savvy Investor does his calculations to figure out that his investment, in this case,
would fetch a return of 43.4% in three years. A good 13.4% more than the government
bond.

Like earlier, the uncertainties still remain. However, since Mr. Savvy Investor earns 43.4%,
he can still take the chance. If the stock fails to go up by 28% in the next two years and
instead goes up by just 17%, he will still make a return of 31%! In other words, the higher
return provides a margin of safety.
Hence, the higher rate of return over the government bond for the same period makes Mr.
Savvy Investor prefer the second option of investing in the stock.
What made him go for the second option?
The 13.4% extra return over the government bond. This 'extra return' that induces our Mr.
Savvy Investor to choose the more uncertain investment option, which is called 'Risk
Premium".

A financial textbook will tell us that risk premium is the 'reward' for holding a risky
investment rather than a risk-free investment.
The extra return that the stock market or a stock must provide over the risk-free rate of
return to compensate for the market risk is called "Equity Risk Premium".
In case of Mr. Savvy Investor, the extra return of 13.4% over the risk-free 30% rate of return
on the government bond defines his "equity risk premium."
How do you determine 'equity risk premium?' What is the right premium to settle for?
What is 'beta?' More of this next time as we brace ourselves to risk the stock market and
brave the uncertainties. As one great statistician wrote: "Humanity did not take control of
society out of the realm of Divine Providence...to put it at the mercy of the laws of chance."

Question:
Analyze the case then comment on Mr. Savvy investment

10.5 Summary

Portfolio means a collection or combination of financial assets (or securities) such as
shares, debentures and government securities.
Business portfolio analysis as an organizational strategy formulation technique is based
on the philosophy that organizations should develop strategy much as they handle
investment portfolios.
Modern Portfolio Theory (MPT) proposes how rational investors will use diversification
to optimize their portfolios, and how a risky asset should be priced.
The basic concepts of the theory are Markowitz diversification, the efficient frontier,
capital asset pricing model, the alpha and beta coefficients, the Capital Market Line and
the Securities Market Line.
A portfolio's return is a random variable, and consequently has an expected value and a
variance.

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