Chapter 15 Part 2 Flashcards
The mean (average) return on an investment can be calculated two different ways-arithmetically and geometrically.
A simple arithmetic mean is calculated by adding the points in a data set, and then dividing the sum of those data points by the number of points in that data set. Geometric means incorporate the increase or decrease that can take place with an investment, and factors the volatility into the return.
A dollar-weighted rate of return is
another form of internal rate of return. It measures how much an individual investor’s portfolio will return on average and compounds the investor’s principal amount over each period at a given rate of return. A dollar-weighted return also includes invesnnent returns (dividends and interest), as well as deposits or withdrawals from the portfolio. If additional money is invested during a period of rising asset values, this will disproportionately increase the portfolio’s return, while withdrawing funds during the same period will disproportionately reduce the overall performance of the portfolio.
A time-weighted return is used to measure
a portfolio manager’s pcrfonnance over time. This value is usually expressed as an annualized rate of return when calculating a time-weightcd rate of return, the effect of varying cash inflows is eliminated by assuming a single investment at the beginning of a period and measuring the growth or loss of market value to the end of that period. A lime-weighted return is also considered a geometric mean or average.
When a payment is made in perpetuity, it means
that the payment will be made forever or perpetually. The following example provides the information necessary to calculate the amount of money required to be invested today, at a given rate of interest, that will generate payments in perpetuity
Greg and Val Stefens would like to provide a monthly allowance of $1,000 for all their nieces and nephews, in perpetuity. How much will Greg and Val need to invest today to meet that financial goal, if the annual rate of return is 2%.
If the Stefens want to generate $1,000 per month, that equals $12,000 per year. Since the investment will return 2% annually, divide the amount required annually by the rate of return ($12,000 + .02 = $600,000). Greg and Val Stefens will need to invest $600,000 today in order to provide an allowance of $1,000 a month for their nieces and nephee=ws, forever.
Discounted cash flow (DCF) analysis is a method of
estimating the fair market value of an investment, a company, or a project based on today’s dollars. DCF takes into consideration the value of the future cash flows from an investment, such as a bond, and reduces that value by a discount rate (i.e., the current interest rate found in the market for bonds of similar maturity and risk), to obtain its present value.
The discount rate reflects two things:
the time value of money and the risk premium. This premium reflects the extra return investors demand because they want to be compensated for the risk that the cash flow may not materialize.
Accrued interest will also affect the discounted cash flow value since the buyer is not entitled to the interest that will be paid to the seller. Whether the bond’s price includes any interest accrued since the last payment period will determine if the bond’s price is
dirty or clean. Dirty bond prices include the accrued interest, while clean bond prices do not. Newspapers and traders typically quote bonds in clean prices.
Net present value (NPV) is a valuation method used to
determine the attractiveness of a particular project or investment. It is based on the concept that a dollar today is worth more than a dollar in the future due to the effects of inflation. Net present value is the difference between the discounted amount of future cash flows and the cost of the investment or project. If the result is positive, the project is worth investing in and the company should move fmward with the project. Conversely, if the result is negative, it would not be a good candidate for investment.
for net present value
take present value (cash flow/1+r to whatever year degree) which gives you the present value
Growth analysis
is the method used by investors who are concerned with a company’s future earnings potential. The investors are seeking companies with rapidly growing earnings in the hope that these companies will continue to grow. Growth investors believe that if the company’s earnings are outperforming the market, the stock’s price will continue to increase. Also, as long as the company controls its costs and increases sales, the value of the business will increase and the stock price will grow along with future earnings.
Growth investors usually purchase stocks that have high
price-to-earnings (PIE) ratios, a high level of retained earnings, and low dividend payout ratios. Remember, growth companies tend to retain most of their earnings to finance expansion of operations rather than paying dividends to shareholders.
Value analysis is the method used by investors (or funds) that look for
stocks of companies that are intrinsically undervalued or trading at a discount to their book value. Value investors believe that a company that is out of favor and underperfonning may be overlooked. If the market is efficient and the issuing company continues to generate profits, these stocks are attractive to long-term investors since their depressed prices make these issues a good value. Value stocks are characterized by a low P/E ratio, a history of profits, a high dividend yield, and a low market-to-book ratio.
Modern Portfolio Theory
relationships between risk, correlation, diversification, and returns in various investment portfolios
expected return of an investment/portfolio
is the possible return on the investment weighted by the likelihood that the return will occur.
