Valuation of Securities

Bond Valuation
 What is a BOND?

A legal document containing an acknowledgement of

indebtedness by a company
A long-term debt instrument in which a borrower
agrees to make payments of principal and interest, on
specific dates, to the holders of the bond.
 Reasons for issuing bonds
To reduce cost of capital
To gain the benefit of leverage
Change in EBIT translate into larger change in
EPS
To effect tax savings
To widen the sources of funds
To preserve control
 Key Features of a Bond
Par value face amount of the bond, which
is paid at maturity (assume Rs1,000).
Coupon interest rate stated interest rate
(generally fixed) paid by the issuer. Multiply by
par to get dollar payment of interest.
Maturity date years until the bond must be
repaid.
Issue date when the bond was issued.
Yield to maturity - rate of return earned on
a bond held until maturity (also called the
promised yield).
Bond risk
Interest rate risk
Variability in the return caused by the
changes in the market interest rate.
Default risk
Failure to pay the agreed value of the debt
instrument by the issuer in full.
Marketability risk
Variation in the return caused by the
difficulty in selling the bonds.
Callability risk
Uncertainty created in the returns by the
issuers ability to call the bond at any time
before maturity.
 What Determines Bond
Prices?
Current market interest rates: Bond prices tend to
increase when interest rates fall and decrease when
rates rise.
Inflation: High inflation will devalue a bond.
Liquidity: The ease and cost of trading a particular
bond will affect the price.
Political risk: People tend not to invest when the
government seems unstable.
 Types of Bonds
I. Classification on the basis of Variability of Coupon
Zero Coupon Bonds
Zero Coupon Bonds are issued at a discount to their
face value and at the time of maturity, the
principal/face value is repaid to the holders. No interest
(coupon) is paid to the holders and hence, there are no
cash inflows in zero coupon bonds.
The difference between issue price (discounted price)
and redeemable price (face value) itself acts as interest
to holders.
The issue price of Zero Coupon Bonds is inversely
related to their maturity period, i.e. longer the maturity
period lesser would be the issue price and vice-versa.
These types of bonds are also known as Deep
Discount Bonds.
Floating Rate Bonds
In some bonds, fixed coupon rate to be provided to the
holders is not specified. Instead, the coupon rate keeps
fluctuating from time to time, with reference to a
benchmark rate. Such types of bonds are referred to as
Floating Rate Bonds.
For better understanding let us consider an example of
one such bond from IDBI in 1997. The maturity period of
this floating rate bond from IDBI was 5 years. The coupon
for this bond used to be reset half-yearly on a 50 basis
point mark-up, with reference to the 10 year yield on
Central Government securities (as the benchmark). This
means that if the benchmark rate was set at X %, then
coupon for IDBIs floating rate bond was set at (X + 0.50)
%.
Fixed
Stays same until maturity; ie: buy a Rs 1000 bond with 8%
fixed interest rate and you will receive Rs 80 every year
until maturity and at maturity you will receive the Rs 1000
back.

Payable at Maturity
Receive no payments until maturity and at that time you
receive principal plus the total interest earned compounded
semi-annually at the initial interest rate.
II Classification on the Basis of Variability of Maturity
Callable Bonds
The issuer of a callable bond has the right (but not the
obligation) to change the tenor of a bond (call option). The
issuer may redeem a bond fully or partly before the actual
maturity date. These options are present in the bond from the
time of original bond issue and are known as embedded
options.

This embedded option helps issuer to reduce the costs

when
interest rates are falling, and when the interest rates are rising
it is helpful for the holders
Puttable Bonds
The holder of a puttable bond has the right (but not an
obligation) to seek redemption (sell) from the issuer at any
time before the maturity date.
In riding interest rate scenario, the bond holder may sell a
bond with low coupon rate and switch over to a bond that
offers higher coupon rate. Consequently, the issuer will have
to resell these bonds at lower prices to investors.

Therefore, an increase in the interest rates poses additional

risk to the issuer of bonds with put option (which are
redeemed at par) as he will have to lower the re-issue price
of the bond to attract investors.
Convertible Bonds
The holder of a convertible bond has the option to
convert the bond into equity (in the same value as of the
bond) of the issuing firm (borrowing firm) on pre-specified
terms.
This results in an automatic redemption of the bond
before the maturity date. The conversion ratio (number of
equity of shares in lieu of a convertible bond) and the
conversion price (determined at the time of conversion) are
pre- specified at the time of bonds issue.

Convertible bonds may be fully or partly convertible.

For the part of the convertible bond which is redeemed, the
investor receives equity shares and the non-converted part
remains as a bond.
3) Classification on the basis of principal repayment
Amortizing Bonds
Amortizing Bonds are those types of bonds in which the
borrower (issuer) repays the principal along with the
coupon over the life of the bond.
The amortizing schedule (repayment of principal) is
prepared in such a manner that whole of the principle is
repaid by the maturity date of the bond and the last payment
is done on the maturity date. For example - auto loans,
home loans, consumer loans, etc.
 BOND VALUATION
Intrinsic Value of a bond:

Fixed annual interest payment Fixed Principal Repayment

where, C : Annual interest (coupon) payable

M: Principal amount payable at maturity
r: Required return
n : Maturity period of the bond

P = C* PVIFA + M* PVIF
A debenture of Rs. 100 face value that
carries an interest rate of 14% is
redeemable after 6 years at par.
Calculate value of bond if:

a) Required rate of return is 14%

b) Required rate of return is 16%
c) Required rate of return is 16% and bond
redeemable at 2% premium
 Bond values over time

At maturity, the value of any bond must

equal its par value.
If kd remains constant:
The value of a premium bond would
decrease over time, until it reached
$1,000.
The value of a discount bond would
increase over time, until it reached
$1,000.
A value of a par bond stays at $1,000.
 The price path of a bond

What would happen to the value of this bond if

its required rate of return remained at 10%, or at
VB 13%, or at 7% until maturity?

1,372 kd = 7%.
1,211
kd = 10%.
1,000
837
775 kd = 13%.
Years
to Maturity
30 25 20 15 10 5 0
 BOND YIELD MEASURES
(Price gain or loss during + (Coupon interest)
(1) Holding period holding period)
rate of return : Purchase Price at the beginning of the holding
period

Coupon Interest
`(2) Current Yield: Market Price

(3) Yield to Maturity (kd) :

OR k = C + (M-P)/n Where M= maturity value

0.4*M+0.6*P P= present price
n= years to maturity

(4) Realized Yield to Maturity

 Yield to Maturity
YTM is the rate of return, which an investor can expect to
earn if the bond is held till maturity.
YTM is the single discount factor that makes present
value of future cash flows equal to current price of the
bond
Calculated based on assumption
No default
Bond hold till maturity
All the coupon payments should be reinvested
immediately at the same interest rate as the same
yield to maturity of the bond.
 Example: The par value of the bond of ABC Ltd. is Rs
1500. Kabir purchased this bond for Rs. 1450. The bond
carries a coupon rate of 7%. Compute the following:
a. Return on the bond if Kabir sells the bond for Rs.1650 an
year later.
b. Current yield on the bond if the current market price is Rs
1458.
c. The approximate yield to maturity if the maturity period for
the bond is 6 years and it is currently traded at Rs 1458.
 Solution:
a. The holding period rate of return =

= 0.21 or 21%.

b. Current yield = = =0.072 or 7.2%

c. Approximate YTM is computed as:

= 0.076 or 7.6%.
 Problem (QP)
TCS Limited issued a Rs. 100 par value 20
years bond with 12% coupon rate 10
years ago
i) Assuming annual interest payments
calculate the value of the bond if
required rate of return is 8%
ii) If the bond is currently trading at 112,
Calculate YTM
 Problem (QP)
Arvind considers Rs. 1000 par value bond
bearing a coupon of 11% that matures
after 5 years. He wants a minimum yield to
maturity of 15%. The bond is currently sold
at Rs. 870. Should he buy the bond?
 Problem (QP)
Prem is considering the purchase of a bond
currently selling at Rs. 878.50. The bond has
four years to maturity, face value of Rs. 1000
and 8% coupon rate. The next annual interest
payment is due after one year from today. The
required rate of return is 10%

a. Calculate the intrinsic value of the bond.

Should Prem buy the bond?

a. Calculate the YTM of the bond?

 Realized Yield
YTM calculation assumes that the cash flows
received are reinvested at a rate equal to the
yield to maturity
This assumption is not valid as reinvestment rate
may differ
So realized yield to maturity is given by
Present market price(1+r)n =future value
 Yield to Call

Where C= annual interest

M= call price
N= no of years until the assumed call date
 BOND VALUE THEOREMS

Bond values depends on 3 factors

The expected yield to maturity or the required rate of
return
Number of years to maturity
coupon rates.

On the basis of this bond value theorems have been evolved.

 Theorem 1
If the market price of the bond increases, the yield
would decline & vice versa

When all other values are constant except the market price
The bond with lower market price will have higher yield.
 Theorem 2
If the bonds yield remains the same over its life, the
discount or premium depends on the maturity period.

Bonds with a short term sells at a lower discount

than the bond with a long term to maturity.
 Theorem 3
If a bonds yield remains constant over its life, the
discount or premium amt will decrease at an
increasing rate as its life gets shorter.
E.g. bond with face value of Rs 1000/- & maturity of
5 yrs with 10%YTM

PV of bond approaches to par value at maturity

 Theorem 4
A raise in the bonds price for a decline in the bonds
yield is greater than the fall in the bonds price for a
raise in the yield.
Example: A coupon-bearing bond of Sun Ltd. has a par
value of Rs. 1000 and a coupon rate of 8%. The
maturity period for the bond is 4 years. Currently the
YTM of the bond is 8%. Analyze the effect of the
bonds price if
(a) YTM increases by 2%
(b) YTM decrease by 2%.
 Solution:

When coupon
rate = YTM =8%
When YTM When YTM
increases by 2% decreases by 2%

Value of the bond =

Face value ( as per
Theorem 1) = Rs.
1000. Value of the bond Value of the bond
= 80 xx PVIFA + = 80 xx PVIFA +
1000 PVIF(10%,4)
(10%,4) 1000 PVIF(6%,4)
(6%,4)
= Rs. 936.60. = Rs. 1069.20.

From the above computations we can conclude that the change in the bonds
Percentage
price will be greater with a decrease in the bonds YTM change
than the change in
in the price of the
the bonds price with an equal increase in the bonds YTM.
 Theorem 5
The change in the price will be lesser for a percentage
change in bonds yield if its coupon rate is higher.
Example: The bonds of X Ltd. and Y Ltd have the following
features:

X Ltd. Y Ltd.

Face value Rs. 1000 Rs. 1000

Coupon rate 8% 9%
What will be the effect on the values of the bonds of X Ltd. and Y Ltd. if the YTM
increases to 10%?

Therefore,
the
X Ltd. Y Ltd.
percentage
price change
Market price at a in case of
YTM of 8% bonds of
Rs. 1000 Rs. 1033.08 high coupon
rate will be
smaller than
Market price at a in case of
YTM of 10%
Rs. 936.60 Rs. 968.30 bonds of
low coupon
rate, other
things
remaining
Percentage
price change in 6.34% 3.17% the same.
 Determinants of Interest Rates for
Individual Securities
1) Inflation rate: As actual or expected inflation rate
increases, interest rate increases.
2) The real interest rates: It is the rate on a security
if no inflation is expected over the holding period
i = Expected (IP) + RIR
3) Default (Credit) Risk: It is the risk that a security
issuer will default on making its promised interest
and principal payments.As default risk increases,
interest rate increases
4) Liquidity Risk: If a security is illiquid, the investors
add liquidity risk premium (LRP) to the interest
rate on the security.
5) Special Provisions and Covenants: Such as
taxability, convertability and collability affect the
interest rates.
As special provisions that provide benefits to the
security holder increases, interest rate decreases.
6)Term to Maturity: Term structure of interest rates
(yield curve)
 Bond Portfolio Strategies

Conservative Approach / passive strategies

Main focus is high current income
High credit quality bonds are used
Usually longer holding periods
Aggressive Approach
Main focus is capital gains
Usually shorter holding periods with frequent
bond trading
Use forecasted interest rate strategy to time
bond trading
 Passive Bond Portfolio Strategies
Buy-and-Hold Strategy
Investor selection based on quality, coupon and maturity
Match maturity with investment horizon
Modified buy and hold
Indexing Strategy
Money managers cant beat the marketIf you cant
beat them, join them.
Difficulties:
Tracking error - difference between the portfolios return and the
return for the index.
You must know characteristics and composition of the various
indexesIndexes change over time.
 Active Bond Strategies
Active management strategies Interest Rate Anticipation
(Valuation Analysis, Credit Analysis, Yield Spread Analysis, and Bond
Swaps)
Riskiest

If i is expected to increase, preserve capital

If i is expected to decrease, make capital gains
Objectives are achieved by adjusting the portfolios duration
(maturity).
Shorten duration if rates are expected to
Play the Reinvestment advantage card and get Cash flow ASAP (liquidity)
Lengthen duration if rates are expected to
Play the Interest rate card lower coupons and play on an increase in
bond prices
 Bond Duration

Bond Duration: A measure of bond price

volatility, which captures both price and
reinvestment risk and which is used to
indicate how a bond will react in different
interest rate environments

Bond Duration is the average amount of time that

it takes to receive the interest and the principal
 Bond Duration (contd)

Improvement over yield-to-market because

factors-in reinvestment risk
Compares the sensitivity to changes in
interest rates
Calculates the weighted average of the cash flows
(interest and principal payments) of the bond,
discounted to the present time
 The Concept of Duration

Generally speaking, bond duration

possesses the following properties:
Bonds with higher coupon rates have shorter
durations
Bonds with longer maturities have longer
durations
Bonds with higher YTM lead to shorter
durations
 The Concept of Duration
(contd)
Bond duration is a better indicator than
bond maturity because of impact of interest
rates on bond price (price volatility)
If interest rates are going up, hold bonds with
short durations
If interest rates are going down, hold bonds with
long durations
 Measuring Duration

Steps in calculating duration

Step 1: Find present value of each coupon or
principal payment
Step 2: Divide this present value by current market price
of bond
Step 3: Multiple this relative value by the year in which
the cash flow is to be received
Step 4: Repeat steps 1 through 3 for each year in the
life of the bond then add up the values computed in
Step 3
 Table 11.1 Duration Calculation for a
7.5%, 15-Year Bond Priced to Yield 8%
 Duration and Price Changes
Bond price changes as prevailing interest rate (YTM)
changes Using duration we can find change in bond price
The relationship b/w duration of the bond & its price
volatility for a change in market int rate is given by
p/p = -D* y
Where p/p = Percentage change in Bond Price
-D* = modified duration, negative sign is put because
yield & price change are inversely related
y = change in the yield

D
So Modified Duration D* = ------------------
(1 + Y)
D = Duration
Y= market yield
Problem (QP)
Miss Sania buys a bond with four year to
Maturity. The bond has a coupon rate of
9 percent and is priced Rs. 100 in the
market.
i) What is the duration of the bond?
ii) What will be the percentage change in
the price of the bond if the interest rate
rises to 10 percent?
 Duration

i (1 +r) PVIFA(r,n) + n (r i) PVIF(r,n)

D = ---------------------------------------------------
i + (r i) PVIF(r,n)

D = 3.53 years
 Duration and Price Changes
Percentage change in Bond Price
= Modified Duration

D 3.53
= ------------------ = ----------------- = 3.21
(1 + y ) (1 + 0.1 )
% change in price = - 3.21(0.01) =0.032
 Bond Immunization
Strategy to derive a specified rate of
return regardless of what ever happens
to market interest rates over holding
period
Seeks to offset the opposite changes in
bond valuation caused by price risk and
reinvestment risk
Price risk: change in price of the bond
value caused by interest rate changes
Reinvestment risk : as coupon
payments are received, they are
reinvested at higher or lower rates
than original coupon rate
 Bond immunization occurs when the average
duration of the bond portfolio just equals the
investment time horizon.
i.e. by matching the outflow duration with
cash inflow duration.
Investment outflow = X1* duration of
bond1+ X2 * duration of bond 2
Where X1 & X2 are proportion of
investment in bond 1 & 2.
So Immunization means protecting a bond
portfolio from damage due to fluctuations in
market interest rates
It is rarely possible to eliminate interest
rate risk completely
Valuation of Equity and
Preference Shares
 Equity shares are more difficult to analyze as there
is no limited life & well defined cash flows.
Basic principles of valuation remain same only the
factors of growth & risk create greater complexity.
Equity analysts employs two kinds of analysis
Fundamental analysis
Technical analysis
Fundamental analysis assess the fair market value
by examine the assets, earning prospects, cash
flow projections & dividend potential.
Technical analysis rely on price & volume trends &
other market indicators to identify trading
opportunities.
 BALANCE SHEET
VALUATION

BOOK VALUE : Net worth divided by total no. of

outstanding equity shares.
Based on accounting conventions & policies, where are
subjective & arbitrary.
BV measured using historical data which is often divergent
from current economic value.
LIQUIDATION VALUE: Liquidation value of the
business divided by total no. of outstanding equity
shares.
2 critics 1) very difficult to estimate realized value 2) doesnt reflect
earning capacity
 REPLACEMENT COST: The price that will
have to be paid to replace an existing
asset with a similar asset, Cost to replicate
the company by starting from scratch.
Major limitations is organizational capital not
shown in balance sheet
Organizational capital is the value created by
bringing together employees, customers,
suppliers, managers & others
So along with this even the focus should be
on expected future dividends, earnings, cash
flows to estimate value of a firm.
 Dividend Discount Model

P0 = Intrinsic/ Present value of Share

D= Dividend
P1=Price at end of period
k = required rate of return
If price of the equity share is expected to grow
at a rate of g percent annually
 DIVIDEND DISCOUNT MODEL
SINGLE PERIOD VALUATION MODEL
D1 P1`
P0 = +
(1+r) (1+r)
MULTI - PERIOD VALUATION MODEL
Dt
P0 =
t=1 (1+r)t
ZERO GROWTH MODEL
D
P0 =
r
CONSTANT GROWTH MODEL
Problem (QP)
Vigilent company stock is currently trading at Rs.
25 per share. The stock is expected to pay Rs.
1 as dividend per share at the end of next year.
It is reliably estimated that the stock will be
available at Rs. 29 at the end of one year.
a) If the forecasts about the dividend and price
are accurate, is it advisable to buy at the
present price? His required rate of return is
20%
b) If the investor requires 17% return when the
dividend remains constant what should be the
price at the end of first year.
 CONSTANT GROWTH MODEL( Gordon model)
It assumes that dividends per share grows at a
constant rate(g) then the value of share is given by
D1
P0 =
rg
It assumes that 2 factors drive the growth
Plough back ratio( 1- dividend )
Return on equity( ROE)
Two Stage Growth model
Assumes that usually there will be extraordinary
growth ( good or bad) for a finite no of years &
thereafter the normal growth rate will prevail
indefinitely.
TWO - STAGE GROWTH MODEL
H model
Based on following assumption
While the current dividend growth rate (g a)is
greater than (gn), the normal run growth rate,
the growth rate declines linearly for 2H years
After 2H years the growth rate becomes gn
At H years the growth rate is exactly halfway
b/w ga & gn
 H MODEL

ga
gn

H 2H
H= one half of the period during which ga will level off to gn

VALUE BASED PREMIUM DUE TO

ON NORMAL ABNORMAL GROWH
GROWTH RATE RATE
Problem (QP)
If a preferred stocks annual dividend is Rs.
4 and the required rate of return is 10%.
What is the worth of preferred stock
today?

D 4
P0 = ---------- = -------- = 40
k 0.1
Problem (QP)
Smart Tyres and Brisk Tyres companies shares are
presently sold at Rs. 60 and Rs. 100 respectively.
Annual dividends over the next year are expected to be
Rs. 1.5 and Rs. 2.5 respectively. Smarts dividends are
expected to grow at 10% per annum in the future and
Brisks by 9%. Financial analysts have estimated the
likely prices for the year ahead on two stocks to be Rs.
66, Rs. 72 and Rs. 75 for Smart, and Rs. 114, Rs. 126
and Rs. 132 for Brisk.
a) You are asked to examine the return of each companys
stock. Choose one stock to be purchased for a holding
period of one year. Support your choice
b) If the investors required rate of return is 12% and he
wants to hold the stock for a longer period. Which stock
would you suggest. Why?
TWO - STAGE GROWTH MODEL : QP
 ILLUSTRATION: H LTD

D0 = 1 ga = 25% H=5
gn = 15% r = 18%
1 (1.15) 1 x 5(.25 - .15)
P0 = +
0.18 - 0.15 0.18 - 0.15
= 38.33 + 16.67 = 55.00
Three Stage Dividend Discount Model: This has an initial
phase of stable high growth that lasts for a certain period. In the
second phase the growth rate declines linearly until it reaches the
a final stable growth rate. This model improves upon both
previous models and can be applied to nearly all firms.
For Ex. Analysts expect that X- pro Ind. is expected to declare dividend of Rs.1.16
next year and is expected to grow at 14% p.a. for four years thereafter. After this
period the growth rate will slow from 14% pace to the 7% rate linearly over the course of
10 years and will stabilize at 7% thereafter. . If an investor with a 10% required return
wants to invest in X- pro, how much would that investor be willing to pay for a share
today?
First of all , we need to calculate the present value of the dividends for next five years-
The terminal value for second and third phase can be
estimated using the two-stage H model = (1.96 * 1.07)/(0.10
- 0.07) + (1.96 * 5 * (0.14 - 0.07))/(0.10 - 0.07) = Rs.69.90 +
Rs.22.86 = Rs.92.76.

It is the value at the end of five years, so it must be

discounted back to the present value @ 10%. The present
value is thus Rs. 92.76/1.10^5 =Rs.57.60.

Adding the present value of the terminal value to the

present value of the dividends for the first five years, we
get Rs. 57.60 +Rs.5.67 = Rs.63.27 ( the value of a share )
 The FCF Discount Model
Akin to the dividend discount model with a
significant change FCF replaces dividend in
the models.
FCF is the cash flow available for distribution to
shareholders after providing for the investments
in fixed assets & net working capital required to
support the growth of the firm.
FCF= NOPAT Net Investment.
 Relative Valuation Techniques

1) P/E Ratio ( Earnings Multiplier Approach) : A valuation ratio

of a company's current share price compared to its per-share
earnings.

Calculated as:
P/E Ratio = Market value per share / Earnings Per Share

For example, if a company is currently trading at Rs.40 a share

and earnings over the last 12 months were 5 per share, the P/E
ratio for the stock would be 8 (40/5).

2) The value of a stock under this approach is estimated as

follows, P0 = E1 * P0/E1

Where P0 is the estimated value, E1 is the estimated

earnings per share, and P0/E1 is the justified P/E Ratio
Determinants of P/E ratio
derived from dividend discount model

Where D1= E1(1-b). b= plough back ratio, E1 = estimated earnings per share
& g = ROE * b

Dividing both the sides by E1 we get

Factors that determine the P/E ratio are

1)Dividend payout ratio,(1-b)
2)The required rate of return, r
3)The expected growth rate, ROE*b
 GROWTH AND P / E MULTIPLE
CASE A : NO GROWTH CASE B : 10 PERCENT GROWTH
YEAR 0 YEAR 1 YEAR 0 YEAR 1
TOTAL ASSETS 100 100 100 110
NET WORTH 100 100 100 110
SALES 100 100 100 110
PROFIT AFTER
TAX 20 20 20 22
DIVIDENDS 20 20 10 11
RETAINED
EARNINGS - - 10 11

CASE A CASE B
NO GROWTH GROWTH
DISCOUNT DISCOUNT DISCOUNT DISCOUNT DISCOUNT DISCOUNT
RATE: 15% RATE: 20% RATE: 25% RATE: 15% RATE: 20% RATE: 25%
VALUE 20 / 0.15 20 / 0.20 20 / 0.25 10 / (0.15 10 / (0.20 10 / (0.25
- 0.10) - 0.10) - 0.10)
= 133.3 = 100 = 80 = 200 = 100 = 66.7
PRICE- 133.3 / 20 100 / 20 80 / 20 200 /20 100 / 20 66.7 / 20
EARNINGS = 6.67 = 5.0 = 4.0 = 10.0 = 5.0 = 3.33
MULTIPLE
 2) PRICE TO BOOK VALUE RATIO (PBV RATIO)

Market price per share at time t

PBV ratio =
Book value per share at time t

The PBV ratio has always drawn the attention of investors.

During the 1990s Fama and others suggested that the PBV
ratio explained to a significant extent the returns from
stocks.
 3) PRICE TO SALES RATIO (PSR RATIOS)

In recent years PSR has received a lot of attention as a

valuation tool. The PSR is calculated by dividing the
current market value of equity capital by annual sales of
the firm.

Portfolios of low PSR stocks tend to outperform

portfolios of high PSR stocks.

It makes more sense to look at PSR/Net profit margin as

net profit margin is a key driver of PSR.
 Capital Asset Pricing Model
(CAPM)
Required rate of return of a stock= E(Ri)

= Rf + [E(RM) Rf] i
Where, E(Ri) is expected return on security i,
Rf = risk free return
E(RM) = expected return on market portfolio
i = beta of security i,

A stocks required rate of return = the risk-

free rate of return + the risk premium
Problem (QP)
A stocks Beta is 2 and its mean rate of
return is 15%. The expected rate of return
on the market portfolio is 10%. What is the
risk free interest rate as implied by the
CAPM formula?
Arbitrage Pricing Model - APT (QP)

Instead of measuring security return as a

function of one factor, this model includes
many Betas like
Industrial production
Short term real interest rate
inflation

Ke = Rf + [E(F1)-Rf] B1 + [E(F2)-Rf] B2 + . +
[E(Fk)-Rf] Bk
CAPM can be graphically shown as
SML(Security Market Line) (QP)

SML: ki = kRF + (kM kRF) i

SML is for inefficient portfolios

 CML(Capital Market Line) (QP)

CML: ki = kRF + ((kM kRF)/ m) * i

CML is for efficient portfolios