Financial Statement

Analysis
Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
 Financial
Statement Analysis
Financial Statements
A Possible Framework for Analysis
Balance Sheet Ratios
Income Statement and Income
Statement/Balance Sheet Ratios
Trend Analysis
Common-Size and Index Analysis
 Examples of External Uses
of Statement Analysis
Trade Creditors -- Focus on the
liquidity of the firm.
Bondholders -- Focus on the
long-term cash flow of the firm.
Shareholders -- Focus on the
profitability and long-term health of
the firm.
 Examples of Internal Uses
of Statement Analysis
Plan -- Focus on assessing the current
financial position and evaluating
potential firm opportunities.
Control -- Focus on return on investment
for various assets and asset efficiency.
Understand -- Focus on understanding
how suppliers of funds analyze the firm.
 Primary Types of
Financial Statements
Balance Sheet
A summary of a firms financial position on
a given date that shows total assets = total
liabilities + owners equity.
Income Statement
A summary of a firms revenues and
expenses over a specified period, ending
with net income or loss for the period.
 Basket Wonders Balance
Sheet (Asset Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a
Cash and C.E. $ 90 a. How the firm stands on
Acct. Rec.c 394 a specific date.
Inventories 696 Prepaid Exp d b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by
10 customers.
Current Assetse d. Future expense items
$1,195 Fixed Assets (@Cost) f
already paid.
1030 Less: Acc. Depr. g
e. Cash/likely convertible
(329) Net Fix. Assets $ 701
to cash within 1 year.
Investment, LT 50 Other
Assets, LT 223 Total f. Original amount paid.
Assets b $2,169 g. Acc. deductions for
wear and tear.
 Basket Wonders Balance
Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ 290 a. Note, Assets =
Acct. Payablec 94 Liabilities + Equity.
Accrued Taxes d 16 Other b. What BW owed and
Accrued Liab. d 100 ownership position.
Current Liab. e $ 500 c. Owed to suppliers for
Long-Term Debt f 530 goods and services.
Shareholders Equity d. Unpaid wages, salaries,
Com. Stock ($1 par) g 200 etc.
Add Pd in Capital g 729 e. Debts payable < 1 year.
Retained Earnings h 210 f. Debts payable > 1 year.
Total Equity $1,139 g. Original investment.
Total Liab/Equitya,b $2,169 h. Earnings reinvested.
 Basket Wonders
Income Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2007a
Net Sales $ 2,211 Cost of a. Measures profitability
Goods Sold b 1,599 over a time period.
Gross Profit $ 612 SG&A b. Received, or receivable,
Expenses c 402 from customers.
EBITd $ 210 c. Sales comm., adv.,
Interest Expensee 59 officers salaries, etc.
EBT f $ 151 Income d. Operating income.
Taxes 60 EATg $ e. Cost of borrowed funds.
91 Cash Dividends f. Taxable income.
38 Increase in RE $ g. Amount earned for
53
shareholders.
 Use of Financial Ratios

A Financial Ratio is Types of

an index that relates Comparisons
two accounting
numbers and is Internal
obtained by dividing Comparisons
one number by the External
other. Comparisons
 External Comparisons and
Sources of Industry Ratios
This involves Examples:
comparing the ratios Risk Management
of one firm with those Association
of similar firms or with
industry averages. Dun & Bradstreet
Almanac of
Similarity is important Business and
as one should Industrial
compare apples to Financial Ratios
apples.
 Liquidity Ratios
Balance Sheet Ratios Current

Current Assets
Liquidity Ratios
Current Liabilities

Shows a firms ability For Basket Wonders

to cover its current December 31, 2007
liabilities with its
current assets. $1,195 = 2.39
$500
 Liquidity Ratio
Comparisons
Current Ratio
Year BW Industry
2007 2.39 2.15
2006 2.26 2.09
2005 1.91 2.01
Ratio is stronger than the industry average.
 Liquidity Ratios
Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios
Current Liabilities

Shows a firms For Basket Wonders

ability to meet December 31, 2007
current liabilities $1,195 - $696 = 1.00
with its most liquid $500
assets.
 Liquidity Ratio
Comparisons
Acid-Test Ratio
Year BW Industry
2007 1.00 1.25
2006 1.04 1.23
2005 1.11 1.25
Ratio is weaker than the industry average.
 Summary of the Liquidity
Ratio Comparisons
Ratio BW Industry
Current 2.39 2.15
Acid-Test1.00 1.25
Strong current ratio and weak acid-test
ratio indicates a potential problem in the
inventories account.
Note that this industry has a relatively
high level of inventories.
Current Ratio -- Trend
Analysis Comparison
Acid-Test Ratio -- Trend
Analysis Comparison
 Summary of the Liquidity
Trend Analyses
The current ratio for BW has been rising
at the same time the acid-test ratio has
been declining.
The current ratio for the industry has
been rising slowly at the same time the
acid-test ratio has been relatively stable.
This indicates that inventories are a
significant problem for BW.
BW
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Equity

Total Debt
Financial Leverage
Shareholders Equity
Ratios
For Basket Wonders
December 31, 2007
Shows the extent to
which the firm is $1,030 = .90
financed by debt. $1,139
 Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year BW Industry
2007 .90 .90
2006 .88 .90
2005 .81 .89
BW has average debt utilization
relative to the industry average.
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Financial Leverage
Total Assets
Ratios
For Basket Wonders
Shows the percentage December 31, 2007
of the firms assets
that are supported by $1,030 = .47
debt financing. $2,169
 Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2007 .47 .47
2006 .47 .47
2005 .45 .47
BW has average debt utilization
relative to the industry average.
 Financial Leverage Ratios
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)

Financial Leverage Long-term Debt

Ratios Total Capitalization

Shows the relative For Basket Wonders

importance of long-term December 31, 2007
debt to the long-term $530 = .32
financing of the firm. $1,669
 Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year BW Industry
2007 .32 .30
2006 .32 .31
2005 .37 .32
BW has average long-term debt utilization
relative to the industry average.
 Coverage Ratios
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firms December 31, 2007
ability to cover
interest charges. $210 = 3.56
$59
 Coverage
Ratio Comparisons
Interest Coverage Ratio
Year BW Industry
2007 3.56 5.19
2006 4.35 5.02
2005 10.30 4.66
BW has below average interest coverage
relative to the industry average.
Coverage Ratio -- Trend
Analysis Comparison
 Summary of the Coverage
Trend Analysis
The interest coverage ratio for BW has
been falling since 2005. It has been
below industry averages for the past
two years.
This indicates that low earnings (EBIT)
may be a potential problem for BW.
BW
Note, we know that debt levels are in
line with the industry averages.
 Activity Ratios
Income Statement / Receivable Turnover
(Assume all sales are credit sales.)
Balance Sheet
Ratios Annual Net Credit Sales
Receivables
Activity Ratios
For Basket Wonders
Indicates quality of December 31, 2007
receivables and how
successful the firm is in $2,211 = 5.61
its collections. $394
 Activity Ratios
Income Statement / Avg Collection Period
Balance Sheet
Ratios Days in the Year
Receivable Turnover

Activity Ratios For Basket Wonders

December 31, 2007
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
 Activity
Ratio Comparisons
Average Collection Period
Year BW Industry
2007 65.0 65.7
2006 71.1 66.3
2005 83.6 69.2
BW has improved the average collection
period to that of the industry average.
 Activity Ratios
Income Statement / Payable Turnover (PT)
(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios
For Basket Wonders
Indicates the
December 31, 2007
promptness of payment
to suppliers by the firm. $1551
= 16.5
$94
 Activity Ratios
Income Statement / PT in Days
Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For Basket Wonders
December 31, 2007
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
 Activity
Ratio Comparisons
Payable Turnover in Days
Year BW Industry
2007 22.1 46.7
2006 25.4 51.1
2005 43.5 48.5
BW has improved the PT in Days.
Is this good?
 Activity Ratios
Income Statement / Inventory Turnover
Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For Basket Wonders
December 31, 2007
Indicates the
effectiveness of the $1,599 = 2.30
inventory management $696
practices of the firm.
 Activity
Ratio Comparisons
Inventory Turnover Ratio
Year BW Industry
2007 2.30 3.45
2006 2.44 3.76
2005 2.64 3.69
BW has a very poor inventory turnover ratio.
Inventory Turnover Ratio
--Trend Analysis
Comparison
 Activity Ratios
Income Statement / Total Asset Turnover
Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For Basket Wonders
December 31, 2007
Indicates the overall
effectiveness of the firm $2,211 = 1.02
in utilizing its assets to $2,169
generate sales.
 Activity
Ratio Comparisons
Total Asset Turnover Ratio
Year BW Industry
2007 1.02 1.17
2006 1.03 1.14
2005 1.01 1.13
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?
 Profitability Ratios
Income Statement / Gross Profit Margin
Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the efficiency
of operations and firm $612 = .277
pricing policies. $2,211
 Profitability
Ratio Comparisons
Gross Profit Margin
Year BW Industry
2007 27.7% 31.1%
2006 28.7 30.8
2005 31.3 27.6
BW has a weak Gross Profit Margin.
Gross Profit Margin --
Trend Analysis Comparison
 Profitability Ratios
Income Statement / Net Profit Margin
Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the firms
profitability after taking $91 = .041
account of all expenses $2,211
and income taxes.
 Profitability
Ratio Comparisons
Net Profit Margin
Year BW Industry
2007 4.1% 8.2%
2006 4.9 8.1
2005 9.0 7.6
BW has a poor Net Profit Margin.
Net Profit Margin --
Trend Analysis Comparison
 Profitability Ratios
Income Statement / Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2007
on the assets of the firm
(after all expenses and $91 = .042
taxes). $2,160
 Profitability
Ratio Comparisons
Return on Investment
Year BW Industry
2007 4.2% 9.8%
2006 5.0 9.1
2005 9.1 10.8
BW has a poor Return on Investment.
Return on Investment
Trend Analysis Comparison
 Profitability Ratios
Income Statement / Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders Equity
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2007
to the shareholders of
the firm (after all $91 = .08
expenses and taxes). $1,139
 Profitability
Ratio Comparisons
Return on Equity
Year BW Industry
2007 8.0% 17.9%
2006 9.4 17.2
2005 16.6 20.4
BW has a poor Return on Equity.
Return on Equity --
Trend Analysis Comparison
 Summary of the Profitability
Trend Analyses
The profitability ratios for BW have ALL
been falling since 2005. Each has been
below the industry averages for the past
three years.
This indicates that COGS and
administrative costs may both be too high
and a potential problem for BW.
BW
Note, this result is consistent with the low
interest coverage ratio.
 Summary of Ratio Analyses

Inventories are too high.

May be paying off creditors
(accounts payable) too soon.
COGS may be too high.
Selling, general, and
administrative costs may be too
high.
 Common-size Analysis

An analysis of percentage
financial statements where all
balance sheet items are divided
by total assets and all income
statement items are divided by
net sales or revenues.
Basket Wonders Common
Size Balance Sheets
Basket Wonders Common
Size Balance Sheets
Basket Wonders Common
Size Income Statements
 Index Analyses

An analysis of percentage financial

statements where all balance sheet
or income statement figures for a
base year equal 100.0 (percent) and
subsequent financial statement
items are expressed as percentages
of their values in the base year.
Basket Wonders
Indexed Balance Sheets
Basket Wonders
Indexed Balance Sheets
Basket Wonders Indexed
Income Statements
 Funds Analysis, Cash-Flow
Analysis, and Financial Planning

Flowof Funds (Sources and Uses)

Statement
Accounting Statement of Cash Flows
Cash-Flow Forecasting
Range of Cash-Flow Estimates
Forecasting Financial Statements
 Flow of Funds Statement

A summary of a firms changes in

financial position from one period to
another; it is also called a sources and
uses of funds statement or a statement
of changes in financial position.
Has been replaced by the cash flow
statement (1989) in U.S. audited annual
reports.
 Why Examine the Flow
of Funds Statement
QUESTION?

Why should we bother to

understand a Flow of Funds
Statement that is no longer
required to appear in U.S.
audited annual reports?
 Why Examine the Flow
of Funds Statement
The Flow of Funds Statement:
Includes important noncash transactions
while the cash flow statement does not.
Is easy to prepare and often preferred by
managers for analysis purposes over the
more complex cash flow statement.
Helps you to better understand the cash
flow statement, especially if it is prepared
under the indirect method.
 Flow of Funds Statement

What are funds?

funds

All of the firms investments and

claims against those investments.
Extends beyond just transactions
involving cash.
cash
 Sources and
Uses Statement
The letters labeling
the boxes stand for
Uses,
ses Sources,
ources A L
Assets,
ssets and
Liabilities (broadly
defined). The pluses S - +
(minuses) indicate
increases
(decreases) in
U + -
assets or liabilities.
 BWs Determination
of Sources and Uses
Assets 2007 2006 +/- S/U
Cash and C.E. $ 90 $ 100 - S
Acct. Rec. 394 410 - S
Inventories 696 616 + U
Prepaid Exp 5 5 --
Accum Tax Prepay 10
9 + U
$ 1,140 N/A
Current Assets $ 1,195
Fixed Assets (@Cost) 1030
930 N/A
Less: Acc. Depr. (329) (299) N/A
Net Fix. Assets $ 701 $ 631 + U
Investment, LT 50 50 --
Other Assets, LT 223 223 --
Total Assets $ 2,169 $ 2,044
 BWs Determination
of Sources and Uses
Assets 2007 2006 +/- S/U
Cash and C.E. $ 90 $ 100 $10 S
Acct. Rec. 394 410 16 S
Inventories 696 616 80 U
Prepaid Exp 5 5 --
Accum Tax Prepay 10
9 1 U
Current Assets $ 1,195
$ 1,140 N/A
Fixed Assets (@Cost) 1030
930 N/A
Less: Acc. Depr. (329) (299) N/A
Net Fix. Assets $ 701 $ 631 70 U
Investment, LT 50 50 --
Other Assets, LT 223 223 --
Total Assets $ 2,169 $ 2,044
 BWs Determination
of Sources and Uses
Liabilities and Equity 2007 2006 +/- S/U
Notes Payable $ 290 $ 295 - U
Acct. Payable 94 94 --
Accrued Taxes 16 16 --
Other Accrued Liab. 100 100 --
$ 505 N/A
Current Liab. $ 500
Long-Term Debt 530
453 + S
Shareholders Equity
Com. Stock ($1 par) 200 200 --
Add Pd in Capital 729 729 --
Retained Earnings 210 157 + S
Total Equity $ 1,139 $ 1086 N/A
Total Liab/Equity $ 2,169 $ 2,044
 BWs Determination
of Sources and Uses
Liabilities and Equity 2007 2006 +/- S/U
Notes Payable $ 290 $ 295 $ 5 U
Acct. Payable 94 94 --
Accrued Taxes 16 16 --
Other Accrued Liab. 100 100 --
$ 505 N/A
Current Liab. $ 500
Long-Term Debt 530
453 77 S
Shareholders Equity
Com. Stock ($1 par) 200 200 --
Add Pd in Capital 729 729 --
Retained Earnings 210 157 53 S
Total Equity $ 1,139 $ 1086 N/A
Total Liab/Equity $ 2,169 $ 2,044
Risk and
Return
Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
 Defining Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
of stock?
 Determining Expected
Return (Discrete Dist.)
n
R = ( Ri )( Pi )
i=1

R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,
n is the total number of possibilities.
 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
 Determining Standard
Deviation (Risk Measure)
n
= ( Ri - R )2( Pi )
i=1

Deviation , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining Standard
Deviation (Risk Measure)
n
=
i=1
( Ri - R ) ( Pi )
2

= .01728

= .1315 or 13.15%
 Coefficient of Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = / R
CV of BW = .1315 / .09 = 1.46
 Determining Standard
Deviation (Risk Measure)
n
=
i=1
( R i - R )
2

(n)
Note, this is for a continuous
distribution where the distribution is
for a population. R represents the
population mean in this example.
 Determining Portfolio
Expected Return
m
RP = ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
portfolio.
 Determining Portfolio
Standard Deviation
m m
P =
j=1 k=1
Wj Wk jk

Wj is the weight (investment proportion)

for the jth asset in the portfolio,
Wk is the weight (investment proportion)
for the kth asset in the portfolio,
jk is the covariance between returns for
the jth and kth assets in the portfolio.
 What is Covariance?

jk = j k r jk
j is the standard deviation of the jth
asset in the portfolio,
k is the standard deviation of the kth
asset in the portfolio,
rjk is the correlation coefficient between the
jth and kth assets in the portfolio.
 Correlation Coefficient
A standardized statistical measure
of the linear relationship between
two variables.

Its range is from -1.0 (perfect

negative correlation), through 0
(no correlation), to +1.0 (perfect
positive correlation).
 Variance - Covariance Matrix

A three asset portfolio:

Col 1 Col 2 Col 3
Row 1 W1W1 1,1 W1W2 1,2 W1W3 1,3
Row 2 W2W1 2,1 W2W2 2,2 W2W3 2,3
Row 3 W3W1 3,1 W3W2 3,2 W3W3 3,3

j,k = is the covariance between returns for

the jth and kth assets in the portfolio.
 Portfolio Risk and
Expected Return Example
You are creating a portfolio of Stock D and Stock
BW (from earlier). You are investing $2,000 in
Stock BW and $3,000 in Stock D. D Remember that
the expected return and standard deviation of
Stock BW is 9% and 13.15% respectively. The
expected return and standard deviation of Stock D
is 8% and 10.65% respectively. The correlation
coefficient between BW and D is 0.75.
0.75
What is the expected return and standard
deviation of the portfolio?
 Determining Portfolio
Expected Return
WBW = $2,000 / $5,000 = .4
WD = $3,000 / $5,000 = .6

RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(
.6 8%)
8%
RP = (3.6%) + (4.8%)
4.8% = 8.4%
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 WBW WBW BW,BW WBW WD BW,D
Row 2 WD WBW D,BW WD WD D,D

This represents the variance - covariance

matrix for the two-asset portfolio.
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.4)(.4)(.0173) (.4)(.6)(.0105)
Row 2 (.6)(.4)(.0105) (.6)(.6)(.0113)

This represents substitution into the

variance - covariance matrix.
 Determining Portfolio
Standard Deviation
Two-asset portfolio:
Col 1 Col 2
Row 1 (.0028) (.0025)
Row 2 (.0025) (.0041)

This represents the actual element values

in the variance - covariance matrix.
 Determining Portfolio
Standard Deviation

P = .0028 + (2)(.0025) + .0041

P = SQRT(.0119)
P = .1091 or 10.91%
A weighted average of the individual
standard deviations is INCORRECT.
 Summary of the Portfolio
Return and Risk Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26

The portfolio has the LOWEST coefficient

of variation due to diversification.
 Diversification and the
Correlation Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
 Total Risk = Systematic
Risk + Unsystematic Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return on
stocks or portfolios associated with changes
in return on the market as a whole.
Unsystematic Risk is the variability of return
on stocks or portfolios not explained by
general market movements. It is avoidable
through diversification.
 Total Risk = Systematic
Risk + Unsystematic Risk
Factors such as changes in nations
STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Congress,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Total Risk = Systematic
Risk + Unsystematic Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Capital Asset
Pricing Model (CAPM)
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a securitys expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.
 CAPM Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index
or similar as a proxy).
 Characteristic Line
Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
 What is Beta?

An index of systematic risk.

risk
It measures the sensitivity of a
stocks returns to changes in returns
on the market portfolio.
The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
 Characteristic Lines
and Different Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO
 Security Market Line

Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
 Security Market Line

Rj = Rf + j(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
 Security Market Line
Obtaining Betas
Can use historical data if past best represents the
expectations of the future
Can also utilize services like Value Line, Ibbotson
Associates, etc.
Adjusted Beta
Betas have a tendency to revert to the mean of 1.0
Can utilize combination of recent beta and mean
2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimate
 Determination of the
Required Rate of Return
Lisa Miller at Basket Wonders is attempting
to determine the rate of return required by
their stock investors. Lisa is using a 6% Rf
and a long-term market expected rate of
return of 10%.
10% A stock analyst following
the firm has calculated that the firm beta is
1.2.
1.2 What is the required rate of return on
the stock of Basket Wonders?
 BWs Required
Rate of Return

RBW = Rf + j(RM - Rf)

RBW = 6% + 1.2(
1.2 10% - 6%)
6%
RBW = 10.8%
The required rate of return exceeds
the market rate of return as BWs
beta exceeds the market beta (1.0).
 Determination of the
Intrinsic Value of BW
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock.
She is using the constant growth model. Lisa
estimates that the dividend next period will be
$0.50 and that BW will grow at a constant rate
of 5.8%.
5.8% The stock is currently selling for $15.

What is the intrinsic value of the stock?

Is the stock over or underpriced?
underpriced
 Determination of the
Intrinsic Value of BW

Intrinsic $0.50
=
Value 10.8% - 5.8%

= $10

The stock is OVERVALUED as

the market price ($15) exceeds
the intrinsic value ($10).
$10
 Security Market Line
Stock X (Underpriced)
Required Return

Direction of
Movement Direction of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)