10

LECTURE 1
Since the word “investment” is used in different contexts and
in each context it has a different meaning therefore it is
deemed important that right from the beginning it is clarified
as to what is meant by “investment” in this course. This
course is about investment in securities market; it is not
about investment in corporate assets such as NWC and FA
(investing decisions in corporate finance); nor is it about
investment in an a country’s or province’s infrastructure such
as roads, bridges, schools, hospitals, etc (investment as used
by economists); nor is this course about foreign direct
investments as depicted by foreign entities building factories
in this country. The course may have some relevance for
foreign portfolio investment by foreigners who may be
contemplating investing in Pakistan’s securities market.
Both individual Investors as well as professional money
managers in Pakistan working for institutional investors such
as mutual funds, commercial banks, insurance companies,
investment banks, pension funds, etc, are expected to
benefit most from this course.
THREE QUESTIONS FACED BY INVESTORS

WHAT TO BUY (or Sell):

(please note that selling is the flip side of buying; you are in the market as
long as you have bought some shares and have not sold them. It is called
long position. On the other hand if the shares you had bought earlier have
now been sold then you have “closed your long position”, or simply you
are out of the market. Also if you initiated your entry in the market by
selling some shares which you did not have , then it is called short selling ,
or simply you have short position in the market. You remain in the market
as long as you do not close your short position by buying the same shares.
It is necessary that short position is ultimately closed (called short
covering) because the share you initially sold were not owned by you , in
fact you had borrowed those shares from the broker and sold them in the
market in the hope of making profit by buying these shares when share
price would go down in future. So in short selling you sell first and buy
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later; and you have an open short position in the market until you buy the
shares and return them to the broker from whom you had borrowed them.)

Common sense answer is buy those securities that would

give positive ROR rate of Return), and thus would increase
your wealth.
Wealth after one year = Wealth now (1 + ROR). This can be
written as:
W1 = Wo (1 + ROR). For example You bought OGDC at 100
and it gave 10% ROR in one year so your wealth after one
year is :
W1 = 100 (1 + 0.1)
W1 = 110 Rs. Note that 10% positive ROR has increased
your wealth from 100 to 110 Rs. Similarly if ROR o this share
was negative 7% then after one year your wealth would be:
W1 = 100 ( 1 + -0.07)
W1 = 93 Rs. Negative ROR has decreased your wealth from
100 to 93 Rs. Please also note that investor can increase
their wealth by a) taking short position (sell first, buy later) in
those shares which are likely to give negative ROR; and b) by
taking long position (buy first, sell later) in those shares
which are likely to give positive ROR. So in real life,
investors can use for investment purposes both types of
share to increase their wealth. As shown in example above
7% negative ROR is for the investor who took long position in
that share, that is, she bought it at 100 and sold it at 93.
But for investor who shorted (sold first) this share at 100 and
bought it after one year at 93, the ROR is +7%. Therefore
shares whose expected ROR is negative , should be short
sold; and shares whose expected ROR is positive should be
bought (long position).
To select securities which are expected to increase your
wealth, (give positive ROR in case of long position; and
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negative ROR in case of short position), two types of security

analyses are done by security analysts:
i) Fundamental Analysis
The basics of fundamental analysis have been covered by
you in previous courses ( Corporate Finance I & II). Expected
ROR = (DPS1/Po) + (P1 – Po)/Po. With certain conditions in
place, P1 is estimated as Po (1 + g). DPS1 is estimated as
DPSo(1 + g). Growth rate “g” is estimated as ROE (1 – d).
Whereas ROE = ROIC + (ROIC – Ki) Debt / Equity.
Also ROE = NI/S * S/ TA * TA/OE.
Dividends Payout ratio is DPS/EPS and is denoted here by
“d”. This ROR formula can be rearranged as a pricing
formula known as Gordon Model and DDM (dividend discount
model) with constant growth assumption.
ROR (Kc) = DPS1/Po + (P1 – Po)/Po
(P1 – Po) /Po is growth rate of share price “g”. So the ROR can
be written ROR= ( DPS1/Po) + g
ROR – g = DPS1 /Po
Po (ROR – g) =DPS1
Po = DPS1 / (ROR – g)
Po = DPS1 / (Kc – g). Note that in previous courses Expected
ROR was shown with symbol Kc or Ks.
ii) Technical Analysis
The focus is not on expected ROR, rather it is on estimating
future price. Here it should be emphasized that expected
ROR is based on future expected price (P1 ). More important
difference with the fundamental analysis is in the
methodology of technical analysis because this methodology
insists on using only the data generated in stock market due
to trading in a share, i.e. price of share and volume of its
trading. This approach ignores fundamental financial data of
the company such as sales, total assets, net income, EPS,
DPS, etc; whereas fundamental analysis is based upon using
such data as shown above.
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Technical analysts try to read pattern of a share price over

time; and claims to discover from these past price patterns
future direction of price movement, i.e., increase or
decrease. This approach has an underlying assumption that
past is a good predictor of future, and past price trends are
likely to repeat themselves in future. Therefore a lot of
energy is spent on discovering patterns of share price in the
past periods ; and then those patterns are taken as a guide
for future price patterns.
The purpose of both types of security analyses is to identify
those stocks which are promising and buy those; and also
identify those stocks which are not promising and therefore
not buy those, or if you already have these stocks then sell
them.
As a security analyst, regardless of your preference for the
use of fundament analysis or technical analysis as the
guiding methodology for identifying good buys , your focus
on expected ROR is only half the story, the remaining half is
Risk which must also be considered, i.e. uncertainty about
expected ROR.

WHAT COMBINATION TO BUY

Common sense answer is not to buy a single security. You
know putting all your eggs in one basket ( or putting all your
money in one stock) is too risky because if basket is
damaged due to an unexpected shock, then you stand to
lose all your eggs (or if that Co faces bad times then you
stand to lose big if all your money is invested only in sharers
of that co). Therefore it is advisable to buy a combination of
securities called portfolio of securities; preferably an efficient
portfolio should be bought.
The following questions are relevant in this regard. What is
meant by an efficient portfolio? How to build an efficient
portfolio of securities? Which securities are included in it, and
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which are not? And those included, what proportion of your

own money (OE) is invested in each of those securities (it is
called weight of a security in your portfolio)? Which securities
have positive weight (buy those), and which securities have
negative weight (short sell those) in an efficient portfolio?
What is Expected ROR of Portfolio and what is its total risk ?
Can total risk of portfolio be divided into components such as
diversifiable risk and non diversifiable risk? For an investor,
which risk is relevant while making investment decision?
It is hoped that this course would help you answer these
questions in detail and with mathematical precision. Such
precision is the result of theoretical developments in modern
portfolio theory during 1950s and 1960s due to contribution
of Markowitz, Sharpe, Lintner, and Mossin.

WHEN TO BUY
This is a question about correctly timing your “entry in” and
the “exit from” the market. Common sense answer is: buy a
stock when its price is low and sell it when its price is high.
But in practice how can one know that today’s price is the
lowest, and it won’t go down further and therefore today is
the best time to buy. Or today’s price is the highest and
therefore today is the correct time to sell; and tomorrow or in
future price won’t go up further. Is it not possible that price
may go down further tomorrow and then you would regret
that you should have waited one more day so you could have
bought even cheaper that particular stock?
======================
This dilemma leads to an interesting question: can anyone
consistently time the market (exit and entry) correctly? This
question also can be posed as: If anyone has the ability to
beat the market consistently? Beating the market means to
buy a stock before its price goes up and selling it before its
price falls. Numerous research studies have shown that no
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portfolio manager has shown such ability consistently.

Showing this ability once or twice is not the issue; ability to
always buy at the lowest price and sell at the highest price in
any given time period (that is , correct timing to enter and
exit the market) is the issue. No investor has shown such
ability; be they individuals, or professional money managers
(portfolio managers), or institutions with huge research and
computational resources at their disposal.
Here it must be stated that those who do Technical Analysis
claim to be able to correctly judge if price is now too high
and therefore it is time to sell (Over Bought Market); or price
is now too low and therefore it is time to buy (Over Sold
Market). But empirical testing of their claimed trading
strategies (called systems) have shown conclusively that no
system of trading based on technical analysis was found
capable of generating correct buy and sell signals for their
users on a consistent basis, with some exceptions found
about “momentum based trading strategies”.
What This Course Aims to Teach
This course is aimed at learning the answers to the first two
questions because these are answerable questions. The
third question about the market timing is not answerable;
therefore this course won’t pretend to teach the answer to
the third question. Generally the issue of timing is more
relevant for the short term traders who frequently buy and
sell almost on daily basis; and now a days, due to ease in
order execution as a result of information technology
revolution, even intra-day trading is becoming easier and
popular.
There is strong support in research literature for the “Buy
and Hold” strategy over a reasonably long period of time.
Such long term investors are more likely to be better-off in
terms of increase in their wealth than the short term traders.
But unfortunately even the professional money managers
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working for mutual funds, pension funds, treasury

departments of banks, etc, are evaluated on quarterly basis.
This performance evaluation culture results in a bias in favor
of showing good results every quarter and therefore leads to
excessive attention to market timing.
Actual ROR , Historic ROR, Realized ROR, Ex-post-
Facto ROR
On shares of companies, Actual ROR for one period (usually
one year) investment is = Realized capital gains yield +
Realized dividend yield; whereas realized capital gains yield
is (selling price - buying price ) / buying price; and realized
dividend yield is DPS (dividend per share in Rs) received /
buying price. This actual ROR needs no theory, it is a
historical fact, and it is actually available for past periods for
all the shares, so there is no argument about it.
Example: Realized ROR
For example if you bought on January 1 a share of MCB at
200 and received during the year DPS of Rs 10, and sold the
share after one year on December 31 for Rs 250. Then your
actual, or realized, or ex-post facto ROR is:
Realized Capital Gains Yield = (250 - 200) / 200 = 25%
Realized Dividend Yield = 5 / 200 = 2.5%
Realized ROR = 25% + 2.5% = 27.5% per year.
Since all of this has HAPPENED, it is a fact, there is no
ambiguity about it, and this information is available to all
investors, therefore actual or realized RORs are not the issue;
and more importantly these RORs are no guarantee, or even
a good reliable guide, for future ROR from the same share for
the next period or next year.
But the tendency to project the past into future and making
expectation about future ROR of a stock based upon its past
RORs is wide spread. Probably it is a reflection of human
inclination, as depicted in many other spheres of life, to
believe that the patterns of past would continue to survive in
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future. It is likely that abhorrence to change and a fear of

unknown is the basis of such thought patterns.
In any case there is no reason to believe that a share which
has given 60% ROR last year would give 60% ROR next year
as well; rather it has happened many times that a co
reporting very high ROE in one year, went bankrupt the next
year.

Expected ROR , Future ROR, Ex-ante ROR

But investors making investment decision today are
interested in expected ROR , or ex-ante ROR, which they
hope to earn after completion of a holding period, usually
one year. There are theories about such ROR, and since it is
a future oriented number therefore it has to be estimated by
investors before making the investment decision. Usually
such estimation is done for one period which is usually next
one year.
The skill of security analyst lies in estimating expected ROR
for the next year, and this skill of a security analyst is judged
by the accuracy of her estimated expected ROR when it is
compared after one year with the actually realized ROR from
that particular security. Note that estimating the ROR for
next year requires estimating 2 items:
a) P 1 , that is price of the security after one year.
b) DPS1, that is expected cash dividend per share that stock
is likely to give to the stockholders during next year.
Since both these items are estimated for the next year
therefore expected ROR is as good as these estimates are.
Expected ROR = (P 1 - Po)/ Po + ( DPS 1 / Po ) .
In this expression Po refers to current price of share which is
available and needs no estimation.
Please note that estimating DPS for next year requires
estimating EPS for the next year, which in turn requires
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estimating NI for the next year, which ultimately requires

estimating income statement for the next year. As Income
statement for the next year cannot be estimated without
estimate of an asset base, therefore it inevitably leads us to
estimation of balance sheet for the next year as well. These
forecasting exercises you have done in your previous courses
such as Corporate Finance II.
Estimating next year share price (P 1 ) is more tricky;
applying a growth rate on current price gives P1 = Po (1 +
g); in this formulation the dispute is about the right
methodology for estimating growth rate of share price.
Remember under assumption of 5 major policies remaining
unchanged next year, this growth rate can be ROE (1 - d).
But this condition of no-change in 5 policies is rather
restrictive and therefore unrealistic in most cases because
keeping the management performance un-changed in 5
major areas of performance is a tall order. To be specific
performance in the following 5 areas should be same as last
year’s performance , i.e., no change in: 1) net profit
margin, 2) total assets turnover, 3) financial leverage, 4)
dividend payout ratio and 5) number of shares outstanding.
With these restrictions in place, you can estimate:
P1 = Po (1 + g)
DPS 1 = DPS o (1 + g), whereas in both expressions given
above
g = ROE (1 - d)
Example: Expected ROR
For example current price of MCB shares is Rs 50, Its ROE
last year was 10% and its dividend payout ratio (d ) was 50%
then you would conclude that its growth of OE is 10% (1 -
0.5) = 5%. It has paid Rs 2 DPS in the most recent year, i.e.
DPS o , therefore you would estimate its:
P1 = Po (1 + g) = 50 (1 + 0.05) = 52. 5 Rs for next year ;
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and you would estimate its DPS1 = DPSo (1 + g) = 2(1 +

0.05) = 2.1 Rs for the next year. And based on these
estimates you would estimate expected ROR for the next
year :

(P1 – Po ) / Po + (DPS 1 / Po )
(52.5 - 50) / 50 + ( 2.1 / 50)
0.05 + 0.042
0.092 or 9.2% per year would be your estimate for the
expected ROR from MCB shares for the next year if you
bought it at today’s price.
Another approach used to estimate P1 is estimating next
year’s EPS and multiplying it with current PE ratio of the
Company. Another approach of estimating P1 is to estimate
next year’s BV per share (OE / number of shares) and
multiplying it with current MV to BV ratio of the Company.
If you want to use growth rate to estimate P1 , one approach
to estimating growth rate is to use GNP growth rate as proxy
for the growth rate of share price, such GNP growth rate
estimates are easily available for any country. It is important
to note that there is no single correct answer or approach
available to estimate the requisite inputs for estimating
expected ROR of a share for the next year.
Actual (and also expected) ROR per year for
Multiperiod holding period
For example, you bought on January 1 , 2005 a share of MCB
at 100, and in 2005 it gave you cash dividends of Rs 4, in
2006 cash dividends of Rs 6, in 2007 cash dividends of RS 3,
in 2008 cash dividends of Rs 8, in 2009 cash dividends of Rs
7. At the end of 2009 you sold the share on December 31 for
Rs 250. What was your realized annual ROR from this
investment ?
First put the Cash flows on time line:
Time 0 - 100
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Time 1 4
Time 2 6
Time 3 3
Time 4 8
Time 5 7 + 250 = 257, assuming dividends are given by
the co at the end of each year.
Use CASH mode of FC -100 and enter in data editor all these
cash flows , and solve IRR. You get 23.93% per year. Note:
underlying assumption in this solution, like all IRR
calculations, is that interim cash flows were reinvested at
IRR; it means DPS of 4, 3, 6, and 8 were reinvested to earn
23.93% per year.
Generic ROR on Various Investments
For one year investment, ROR on any instrument has 2
component, namely, an income yield and a capital gains
yield. Income yield is due to cash paid by that instrument
(security or asset) to the investor. For shares this cash
payment is called cash dividends, for bonds it is called
interest payment, on commercial or residential rental
property it is called rent income; but for investment in
paintings, or plots of land, or jewelry there is no cash income.
The second component of ROR , namely, capital gains yield is
due to the increase in price of that investment since you
bought it, it may be a capital loss also if price has declined
since you bought that investment. In case of plots of land,
jewelry, and paintings all the ROR is from capital gains yield.
But in case of investments in share, bonds, and residential or
commercial rental property cash income in the form of
dividends, interest, or rent gives rise to an income yield. For
example ROR on one year investment in shares is:
(selling price – purchase price) / purchase price + cash dividends received
/ purchase price.

ROR on one year investment in bonds is:

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(Selling price – purchase price) / purchase price + interest received /

purchase price

ROR on one year investment in residential or

commercial rental property is:
(Selling price – purchase price) / purchase price + rental income /
purchase price

ROR on one year investment in a plot of land is:

(Selling price - purchase price) / purchase price

ROR on one year investment in Paintings:

(Selling price - purchase price) / purchase price

ROR on one year investment in jewelry is:

(Selling price - purchase price) / purchase price

Note: Selling price does not mean you have to sell it

actually, it means if you had sold it at the end of the
year then at this price you would have sold it because it
was the prevailing price at the end of the year.