MST(F)572

Lecture 2
4th Feb 2016

Topics to be covered today

Risk return trade off

Quantitative and qualitative aspects

Concept of intrinsic value

The Trade-off Between Risk and Return

The Trade-off Between Risk and

Return
The return earned on investments represents the
marginal benefit of investing.

Risk represents the marginal cost of investing.

A trade-off always arises between expected risk

and expected return.
3

The Trade-off Between Risk and

Return
Valuing risky assets is a task fundamental to
financial management
Three-step procedure for valuing a risky asset
1. Determine the assets expected cash flows
2. Choose discount rate that reflects assets risk
3. Calculate present value (PV cash inflows - PV
outflows)
This three-step procedure is called
discounted cash flow (DCF) analysis.
4

Quantitative and qualitative aspects

Quantitative Analysis:

Analyzing income statements, balance sheets, cash flows

Comparing current valuations with historical valuations
Comparing valuations and company financials with other companies in the same industry
Rarely talk to company management
Studies the stock, but not the company (not overly concerned with the companys products or
services)
Doesnt rely on anything other than publicly available data
Doesnt put much weight on the industry or sector, nor the trends of those sectors
Doesnt rely on macro economic trends or overall top down analysis
Usually run diversified portfolios since they dont analyze each company in depth

Qualitative Analysis:
Talking to management

Relies on scuttlebutt: i.e. talking with a companys competitors, vendors and distributors to
gain legal information that others might not have
Analyzing in depth the companys products or services
Determining the capability of the companys management

Determining the competitive advantages a company has or doesnt have

Making judgments on the prospects for the industry or general line of business the company is
in (sustainable, growing, etc)
Often concentrates the portfolio in a select few positions that have been thoroughly
researched

Concept of intrinsic value

Intrinsic value is basically finding answer to one question at what price do YOU think that a
stock is available at a bargain and why?
Understanding intrinsic value is crucial if you are adopting value investing strategy.
Intrinsic value may differ from book value because of brand names, customer base, patents
and other intangibles that are difficult for investors to quantify.
It may also be different from the market value The current quoted price of the share which is
driven by investor sentiments.
It is not possible to find accurately, intrinsic value of a stock.
There are various approaches but no standard formula for calculating the intrinsic value.